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RESTORING CONFIDENCE, CREATING RESILIENCE: A n I n d u s t r y P e r s p e c t i ve o n t h e F u t u r e o f I n t e r n a t i o n a l Financial Regulation and the Search for Stability Institute of International Finance July 2009 The Board of Directors of the Institute of International Finance (IIF) and the IIF’s Special Committee on Effective Regulation are pleased to present this Report to the international ﬁnancial community, and in particular to the ofﬁcial sector as they move toward a reformed framework of ﬁnancial regulation. This Report sets out a global industry perspective on ﬁnancial regulation at the national and international levels and on the reforms being developed under the broad auspices of the G-20 and the Financial Stability Board (FSB). It draws on the insights and experience of the IIF membership. The IIF is the premier global association of ﬁnancial institutions, with over 375 member ﬁrms including most of the world’s largest banks. Our members also encompass a broad range of other ﬁnancial institutions, including a growing number of insurance companies, hedge funds, asset management ﬁrms, and sovereign wealth funds. Weaknesses and failings in industry practices, and deep ﬂaws in important parts of the market—in particular the securitization market—contributed to a grave crisis, compounded by gaps and errors in regulation and supervision and global macroeconomic imbalances. Moving toward greater ﬁnancial stability is essential. Equally essential is that we do so in a manner that does not inhibit sustainable global growth—and this is necessarily a shared endeavor. The industry has made signiﬁcant strides over the past year in addressing the failings revealed by the crisis. With the leadership of the authorities, important advances have been made in correcting vulnerabilities in the market, while at the same time, much progress has been made on the development of more robust regulatory frameworks. Lasting stability depends upon the interaction of well-designed regulation and effectively functioning international markets, the latter exercising discipline on their participants and reinforcing best industry practices. To bring this about requires, inter alia, reforms to ensure that any ﬁrm that is in danger of failing can exit the market in an orderly fashion—regardless of its size or scope of activities. The objective should be a system in which such exits would not have undue impact on a more-resilient market infrastructure, with the burden of loss being appropriately shared by the ﬁrm’s investors and creditors (other than those who are formally protected) and minimizing any residual risk to taxpayers. Such an approach requires stronger international coordination and better cooperation between supervisors, including better cross- border crisis management arrangements. Regulatory reform should be built on an integrated view of markets and regulation. It should promote higher levels of risk-adjusted capital than those prevailing in many areas prior to the crisis, as well as more effective management of liquidity. At the same time, regulatory requirements demand careful calibration—there are many pitfalls that could hinder recovery, limit expansion of credit to the real economy, and threaten renewed job creation. These include arbitrary restrictions on ﬁrm size or business models or, conversely, treating certain ﬁrms as too big to fail. Good progress has been made: now it is essential to avoid any rush to regulation without full consideration of the cumulative impact of proposed changes; care must also be taken not to fragment globalized markets by well-meant but ultimately counterproductive national measures that are not adequately coordinated or harmonized. We have all recognized the need to intensify our work on developing better means of detecting and reducing systemic risk. By deﬁnition this requires a cross-border approach that recognizes systemic risk may well be a function of the interconnectedness among markets, ﬁrms, and products across national boundaries. Approaches to systemic risk should be built around this fundamental understanding and not just focused on a limited number of ﬁnancial institutions. Reinforced regulation on a well-integrated, globally consistent basis is now, more than ever, of paramount importance. In a spirit of shared endeavor this Report sets out, on the one hand, Commitments addressing those aspects where improvements and enhancements are required of the industry, and on the other, Recom- mendations outlining the views of the IIF to the ofﬁcial sector as it carries out the next phase of its critical work. The Institute is grateful for member ﬁrms’ time and expertise, which has made the development of this Report possible. A list of Committee members is included. We look forward to a continued and deepened dialogue with the ofﬁcial sector as they press forward with their work to reform the regulatory and supervisory framework and, together with the industry, develop a more resilient and efﬁcient set of markets and better managed institutions—ultimately providing for greater ﬁnancial stability and resilience. Josef Ackermann Walter Kielholz Chairman of the Management Board and Chairman of the Board of Directors the Group Executive Committee Swiss Reinsurance Company Ltd. Deutsche Bank AG William T. Winters Charles H. Dallara Co-Chief Executive Ofﬁcer Investment Bank Managing Director J.P. Morgan Institute of International Finance Contents Foreword i Board of Directors of the Institute of International Finance (IIF) 1 IIF Special Committee on Effective Regulation 3 Executive Summary 7 Introduction 15 1. Importance of Coordination in an International Market 19 2. A Shared Responsibility to Achieve Resilience 25 3. Achieving Resilience Through the Cycle With Prudential and Accounting Standards 35 4. Financial Stability Through Macroprudential Oversight 55 5. Improving Market Infrastructure and Mitigating Risks of Interconnectedness 65 6. Resisting Fragmentation of International Markets 73 7. Cross-Border Crisis Management and Financial Firm Resolution Regimes 77 Commitments and Recommendations 83 Institute of International Finance • July 2009 ■ iii IIF BOARD OF DIRECTORS Chairman Dr. Josef Ackermann* Chairman of the Management Board and the Group Executive Committee Deutsche Bank AG First Vice Chairman Vice Chairman Vice Chairman William R. Rhodes* Roberto E. Setubal* Francisco González* Senior Vice Chairman President & CEO of Itaú Unibanco Chairman and of Citigroup Banco Multiplo S/A and Vice Chief Executive Ofﬁcer President of Banco Itaú Holding S/A BBVA Treasurer Marcus Wallenberg* Chairman of the Board SEB Hassan El Sayed Abdalla Robert E. Diamond, Jr. Vice Chairman and Managing Director President, Barclays Capital and Arab African International Bank CEO, Investment Banking and Investment Management Yannis S. Costopoulos* Chairman of the Board of Directors Roger Ferguson Alpha Bank A.E. President and Chief Executive Ofﬁcer TIAA-CREF Ibrahim S. Dabdoub Stephen K. Green* Group Chief Executive Ofﬁcer Group Chairman National Bank of Kuwait, S.A.K. HSBC Holdings plc Charles H. Dallara (ex ofﬁcio)* Jan Hommen Managing Director Chairman of the Executive Board Institute of International Finance ING Group Institute of International Finance • July 2009 ■ 1 Jiang Jianqing Corrado Passera Chairman Managing Director and Chief Executive Ofﬁcer Industrial and Commercial Bank of China, Ltd. Intesa Sanpaolo K. Vaman Kamath Baudouin Prot Chairman of the Board Chief Executive Ofﬁcer ICICI Bank Ltd. BNP Paribas Kang Chung Won Yasuhiro Sato President and Chief Executive Ofﬁcer President & CEO Kookmin Bank Mizuho Corporate Bank, Ltd. Walter B. Kielholz James J. Schiro Chairman of the Board of Directors Group Chief Executive Ofﬁcer Swiss Reinsurance Company Ltd. Zurich Financial Services Nobuo Kuroyanagi* Andreas Treichl President & CEO, Mitsubishi UFJ Financial Group, Chairman of the Management Board & Chief Inc. & Chairman, The Bank of Tokyo-Mitsubishi Executive Ofﬁcer UFJ, Ltd. Erste Group Bank AG Gustavo A. Marturet Rick Waugh President President and Chief Executive Ofﬁcer Mercantil Servicios Financieros Scotiabank Klaus-Peter Müller William T. Winters Chairman of the Supervisory Board Co-Chief Executive Ofﬁcer, Commerzbank AG Investment Bank J.P. Morgan Frédéric Oudéa Chairman and Chief Executive Ofﬁcer Xiao Gang Société Générale Chairman Bank of China Ergun Özen President & Chief Executive Ofﬁcer Garanti Bankasi A.S. Secretary of the Board Peter Wallison *Member of the Administrative and Nominations Committee 2 ■ Restoring Conﬁdence, Creating Resilience IIF SPECIAL COMMITTEE ON EFFECTIVE REGULATION Chairmen Mr. Walter B. Kielholz Mr. William T. Winters Chairman of the Board of Directors Co-Chief Executive Ofﬁcer, Swiss Reinsurance Company Ltd. Investment Bank J.P. Morgan Committee Members Mr. Mark Harding Mr. Michael Helfer Group General Counsel General Counsel Barclays PLC Citigroup Inc Mr. Mike Walters Mr. Simon Gleeson Group Head of Compliance Partner Barclays Bank PLC Clifford Chance LLP Mr. Christian Lajoie Dr. René P. Buholzer Head of Group Supervision Issues Managing Director BNP Paribas Global Head Public Policy Credit Suisse Mr. Baudouin Prot Chief Executive Ofﬁcer Mr. Urs Rohner BNP Paribas Vice Chairman of the Board of Directors Credit Suisse Mr. Freddy Van den Spiegel Mr. Richard Spillenkothen Chief Economist - Director Public Affairs Director, Bank Regulatory Consulting Practice Chairman of the IIF Steering Group on Senior Advisor, Center for Banking Solutions Regulation and Supervision Deloitte & Touche LLP BNP Paribas Fortis Mr. Donald F. Donahue Ms. Jill Considine Chairman and Chief Executive Ofﬁcer Chairman The Depository Trust & Clearing Corporation Butterﬁeld Fulcrum Group Institute of International Finance • July 2009 ■ 3 Dr. Hugo Bänziger Mr. Roberto E. Setubal Chief Risk Ofﬁcer and Member of the President & CEO, Itaú Unibanco S/A Management Board Vice President, Itaú Unibanco Holding S/A Deutsche Bank AG Sir Andrew D. Crockett Mr. Helmut Bauer President Managing Director JPMorgan Chase International Regulatory Affairs Deutsche Bank AG London Mr. Kang Chung Won President and Chief Executive Ofﬁcer Mr. Roar Hoff Kookmin Bank Executive Vice President, Head of Group Risk Analysis Dr. Madelyn Antoncic DnB NOR ASA Managing Director and Senior Advisor Lehman Brothers Holding Inc. Mr. Bjørn Erik Næss Chief Financial Ofﬁcer Dr. Mark Lawrence Group Finance and Risk Management Managing Director, Mark Lawrence Group DnB NOR ASA Senior Advisor, McKinsey & Company Mr. Nasser Al Shaali Dr. Philipp Härle Chief Executive Ofﬁcer Director Dubai International Financial Center McKinsey & Company Mr. Wolfgang Kirsch Mr. Saburo Sano Chief Executive Ofﬁcer Senior Managing Director DZ BANK AG Mitsubishi UFJ Financial Group, Inc. Mr. Gregory P. Wilson Mr. Daisaku Abe President Managing Executive Ofﬁcer, Head of Strategic Gregory P. Wilson Consulting Planning Group, Head of IT, Systems & Operations Group and General Manager of Mr. Stephen K. Green Group Strategic Planning Group Chairman Chief Strategy Ofﬁcer HSBC Holdings plc Chief Information Ofﬁcer Mizuho Financial Group, Inc. Mr. George Theuvenet Head of International Affairs Mr. Nick Collier European and International Affairs Executive Director ING Group Head of EMEA Government Relations Morgan Stanley Mr. Carlo Messina Chief Financial Ofﬁcer Mr. Takis Arapoglou Intesa Sanpaolo Spa Chairman of the Board and Chief Executive Ofﬁcer National Bank of Greece S.A. 4 ■ Restoring Conﬁdence, Creating Resilience Mr. Parkson Cheong Mr. Nils-Fredrik Nyblaeus General Manager & Group Chief Risk Ofﬁcer Senior Advisor to the Chief Executive Ofﬁcer Credit & Risk Management Group SEB Group National Bank of Kuwait, S.A.K. Mr. Daniel Amadieu Mr. Ibrahim S. Dabdoub Senior Advisor to the Chief Risk Ofﬁcer Group Chief Executive Ofﬁcer Société Générale National Bank of Kuwait, S.A.K. Mr. H. Rodgin Cohen Mr. Takashi Oyama Chairman Adviser for Global Strategy Sullivan & Cromwell LLP The Norinchukin Group Mr. Carl Eric Stalberg Mr. John P. Drzik Executive Chairman President and Chief Executive Ofﬁcer Swedbank AB Oliver Wyman Mr. Philippe Brahin Mr. Jean-Pierre Beguelin Head of Regulatory Affairs Chief Economist Swiss Reinsurance Company Pictet & Cie Banquiers Mr. Steve Hottiger Mr. John W. Campbell Managing Director & Head of Group Senior Regulatory Services Partner Governmental Affairs Advisory Services UBS AG PricewaterhouseCoopers LLP Mr. Sergio Lugaresi Mr. Eugene A. Ludwig Senior Vice President Founder and Chief Executive Ofﬁcer Head of Regulatory Affairs Promontory Financial Group, LLC Institutional and Regulatory Strategic Advisory UniCredit Group Mr. Morten Friis Chief Risk Ofﬁcer Mr. Peter Buomberger Royal Bank of Canada Group Head of Government and Industry Affairs Member of Executive Staff Mr. Stephen Sanders Zurich Financial Services Group Head of Regulatory & Operational Risk Royal Bank of Scotland Group Mr. Brian J. Porter Group Head, Risk & Treasury Scotiabank Institute of International Finance • July 2009 ■ 5 Executive Summary The only sure foundation for sustainable globalization and rising prosperity for all is an open world economy based on market principles, effective regulation, and strong global institutions. —G-20, London, April 2, 2009 T he crisis that developed two years ago reduced complexity, which are shared market revealed widespread weaknesses in many goals. Markets worked where assets, procedures, ﬁnancial ﬁrms’ business practices, as well and infrastructure were well-understood. The as notable deﬁciencies in market operations. At industry has made signiﬁcant progress on the same time, the crisis exposed misalignments improving underwriting, documentation, and and gaps in regulatory and macroeconomic poli- transparency in securitization markets. cies. Much progress has been made by the ofﬁcial This Report reafﬁrms the commitment of IIF sector in developing a strengthened regulatory members to continue raising market practices framework—one geared more toward containing to the high standard set out in the July 2008 systemic risk. Final Report of the IIF Committee on Market At the same time, the ﬁnancial industry has Best Practices (the Market Best Practices Report), ﬁrmly recognized the need for wide-ranging building on the substantial progress made to date. improvements in business practices—and has The IIF agrees that far-reaching regulatory made tangible progress on implementation. reforms are necessary to guard against systemic These improvements include signiﬁcantly vulnerabilities, ensure robust markets including enhanced risk management; more effective liquid and transparent asset-backed credit liquidity management; greater transparency; and markets, and encourage beneﬁcial innovation. compensation policies aligned with long-term, This would also help ensure that the industry risk-adjusted performance. Deepening these follows through with its commitments. However, reforms by the industry is, together with it is crucial that the cumulative effects of reform improved market discipline, a sine qua non be consistent with market efﬁciency, avoiding for greater systemic stability and an essential rigidities that could stiﬂe growth, job creation, underpinning to more effective regulation and and innovation, or increase the cost of ﬁnancial supervision. services to customers. Asset-backed securities markets have been damaged by the crisis, even “vanilla” products 1. Importance of Coordination that were exempt from the problems of resecu- in an International Market ritizations. Restoring the critical role of these markets is essential to a sound recovery and The G-20 has catalyzed a potentially important can be achieved by greater transparency and new level of international coordination. However, Institute of International Finance • July 2009 ■ 7 recent developments suggest that there has strengthened capabilities in risk nonetheless been “fragmentation” that could aggregation, improved stress testing, weaken the capacity of the global economy to improvement of market-risk management, return to sustainable growth. It is essential that and signiﬁcant investment in risk systems agreement on the high-level principles of reform and data. translate into a high degree of convergence on Increased and Better Quality Capital speciﬁc regulation. This represents an important compared to the position prior to the crisis, challenge for the Financial Stability Board (FSB) in response to market and ofﬁcial-sector and other international organizations. The IIF requirements. The challenge now, for both is committed to deepening its dialogue on these the industry and the ofﬁcial sector, is to issues with the FSB and with each of the interna- develop an appropriate analysis of the tional standard-setters. levels of capital needed to weather times of stress while avoiding overshooting or 2. A Shared Responsibility to Achieve misaligned incentives and assuring that Resilience ﬁnancial stability is balanced with objec- tives for economic growth. Lasting ﬁnancial stability depends on the effective Better Liquidity Risk Management, interaction of markets, ﬁrms, and regulation. including more robust analysis of funding Stability will not be achieved by reliance on one needs and sources, wide application without the others. All must work in concert to of stress-testing techniques, and more achieve resilience, stability, and the efﬁciency substantial liquidity buffers. necessary to support sustainable global growth. Reducing Procyclicality by analyzing its causes, reﬁning provisioning practices, and The Industry’s Demonstrated Commitment making more extensive use of “through- to Change the-cycle” approaches to capital. Fundamental questions about the pre-crisis Reducing Leverage, both on a systemic business conduct of many ﬁnancial ﬁrms have and individual-ﬁrm basis, based on a damaged the industry’s credibility. Strengthening clear recognition of the negative effects of the ability of ﬁrms, market infrastructure, and excessive leverage. markets themselves to withstand stress and Material Improvement on Disclosure and cyclical downswings is essential. The industry Transparency through Pillar 3, together reafﬁrms its commitment to strengthening all with Industry Initiatives to Reform Securi- lines of defense to achieve long-term stability and tization, working toward more trans- to restore the health of the sector and the global parent, liquid, and standardized markets, economy. and also clarifying ﬁrms’ Off-Balance While signiﬁcant advances are being made, Sheet Exposures. much work remains to be done by the industry Signiﬁcant Reforms of Compensation to act on lessons learned in critical areas. The Practices to align them with long-term industry has made substantial progress on, and shareholders’ interests and ﬁrm-wide is committed to, the following: proﬁtability, taking account of overall risk and the cost of capital. The IIF reafﬁrms Materially Improved Risk Management, the wide commitment to implementation including more robust risk governance, of the Compensation Principles set out in the Market Best Practices Report and 8 ■ Restoring Conﬁdence, Creating Resilience welcomes the FSB Principles for Sound Regulation needs to operate in tandem with Compensation Practices.1 meaningful market discipline. For markets to Development with the ofﬁcial sector of a discipline ﬁrms effectively, it must be possible for Better Understanding of the Sources and ﬁrms to exit the market in an orderly manner, Mitigants of Systemic Risk, using this whatever their size or degree of interconnect- understanding in risk management, and edness, with consequences for creditors and working with the ofﬁcial sector on macro- investors. prudential means through which it can be identiﬁed, addressed, and mitigated. Withdrawal Strategies—Restoring Normal Signiﬁcantly enhanced risk management, Markets processing, transparency, and systems While public interventions to secure stability and market infrastructure for carrying on have been necessary, it is necessary now for Credit Default Swaps (CDS) and other governments, central banks, and regulators to Over-the-Counter (OTC) Derivatives develop clear strategies for withdrawal from business. their emergency interventions so as to avoid competitive distortions and restore an effectively The IIF’s Market Best Practices Report, functioning marketplace. together with reports such as the Senior Supervisors Group Report,2 have become benchmarks for large international ﬁrms. The 3. Achieving Resilience Through industry welcomes the use of these reports in the Cycle With Prudential and the supervisory assessment of the quality of risk Accounting Standards management of ﬁrms. It would also be beneﬁcial Current capital, liquidity, and accounting require- to arrange an annual review involving authorities ments need to be better adapted to times of stress and ﬁrms collectively to consider trends, progress, or economic downturn. Measures need to be and shortcomings across the ﬁnancial sector. taken to reduce procyclicality. Revised standards need to be implemented through strong interna- Effective Regulation, Enhanced Supervision, tional coordination. and Meaningful Market Discipline Overall levels of capital relative to pre-crisis Better regulation requires clear objectives, good levels need to be increased within the framework dialogue, and robust impact assessment, while the of a revised Basel II risk-based approach; capital best supervisory response to the crisis is a more must also respond to system-wide cyclical risks rigorous, outcomes-focused approach providing and times of stress. Resources must be built up clear incentives to strong risk management. Firms in good times that are genuinely able to be drawn must ensure that their interaction with regulation upon when needed, and the quality of capital and supervision is positive and non-defensive. needs to be reviewed. International consistency Better regulation requires clear objectives, good in interpretation of capital rules is needed. There dialogue, and robust impact assessment. will be a continuing important role for Tier 2 capital. 1 FSB Principles for Sound Compensation Practices, April 2, Leverage in the system was too high and 2009. needs to be kept under control in the future. 2 Senior Supervisors Group Report, Observations on Risk Focus on leverage as a backstop to capital Management Practices during the Recent Market Turbulence, requirements makes sense—provided there is March 6, 2008. worldwide consistency—but the IIF counsels Institute of International Finance • July 2009 ■ 9 against hardwired “Pillar 1” ratios, which do not Cumulative Effects, the Cost of Error, take into account actual portfolio composition and Timing and may create misaligned incentives. More Conservatism in the design of the new regulatory nuanced leverage indicators should ﬁgure in the regime is appropriate to allow for uncertainty Pillar 2 supervisory review process. and unknowns. Nonetheless, material error in A comprehensive, high-level dialogue on the calibration of new prudential requirements current accounting standards in light of the would have major negative effects, not just on the crisis, involving all relevant parties, remains ﬁnancial industry but on national economies— essential. The most critical need is rapid conver- and ultimately on the global economy. gence of international standards as mandated by It is sometimes overlooked in discussions of the G-20. Work currently in progress to review remedies that generation of reasonable returns fair-value and accrual accounting for ﬁnancial is the foundation of ﬁrms’ viability and ability institutions should continue with urgency. to meet clients’ ﬁnancial needs—and thus to Authoritative guidance should be issued to allow stimulate economic activity. Although it has in the use of reasonable interpretation in assessing certain cases been abused, innovation remains loan loss provisioning under the incurred-loss essential to future progress, in a context of model, pending the in-depth review of provi- stronger risk management, good governance, sioning (which itself is a high priority). and effective supervision. Care must be taken to The IIF has argued that local self-sufﬁciency preserve the beneﬁts of positive innovation. or stand-alone approaches to liquidity regulation All practicable steps should be taken to should be resisted. While acknowledging local assess the cumulative impact of proposed market liquidity needs, the drain on systemic measures, to consider their effect on the avail- resilience created by “trapped pools of liquidity” ability of credit and other ﬁnancial resources must also be recognized. Any new liquidity to the wider economy, and to calibrate the new regulation will be counterproductive unless inter- measures as accurately as possible. If not well nationally coordinated. It is of course necessary assessed, the burdens on intermediation can to hold adequate liquidity buffers; however, overly become so great that global economic activity mechanistic approaches, including mandatory is materially adversely affected, with additional core-funding ratios, should be avoided. costs to consumers and businesses, increased Simpler, more-transparent securitizations, unemployment, and overall negative impacts based on good underwriting and improved on welfare. The IIF recognizes the challenges of transparency, are essential to restoring the ﬂow of carrying out such assessment and offers to work credit to important consumer sectors. Industry with the regulatory community on objective work on the needed improvements continues. analysis of the cumulative net impact of It is equally essential that regulatory and proposed regulatory changes. accounting changes foster the return of robust Proposals need to be produced, agreed upon, securitization markets. and implemented in a timely manner. However, The development of a comprehensive global time is needed to ensure the appropriate standard for the supervision and regulation design, assessment, and calibration of new and of internationally active insurance ﬁrms on a often radical proposals. The dangers of rushed group-wide basis is urgently needed. Interna- regulation must be avoided. In order not to tional solvency standards need to be developed, as compound short-term procyclical effects, the do effective colleges of supervisors for insurance ﬁrms. 10 ■ Restoring Conﬁdence, Creating Resilience introduction of any new measures needs to be market discipline, enforced by a real risk of carefully timed to avoid inhibiting economic loss by their investors and creditors (other than recovery. depositors and policy holders). Accordingly, it should be a priority to implement the infrastruc- 4. Financial Stability Through tural, legal, and process reforms necessary to Macroprudential Oversight ensure that all ﬁrms can exit the market in an orderly fashion and without causing a systemic The IIF agrees that all market participants crisis, regardless of their size, nature, or range of whose activities could materially affect systemic activities. No ﬁrm should be considered “too big stability should fall within the framework of to fail.” macroprudential oversight, including all signif- Given this objective, the ongoing dialogue icant ﬁnancial markets, products, and risks. between large ﬁrms and the authorities should It would be a mistake, however, to create include consideration of all the information formal or public categories of ﬁrms subject to necessary to plan for the orderly exit of the ﬁrm separate systemic regulation. To do so would should that prove necessary. While some have run counter to the multifaceted and quickly suggested ﬁrms make “wills” to be used in case of evolving nature of systemic risk. It would give rise their failure, it is more likely to be productive for to a mistaken sense that systemic risk had been ﬁrms to examine with the authorities the risks corralled within such a category of ﬁrms and that their roles in markets and products create— would distract from the real problem of identi- to help the authorities assess what would happen fying risk in the interaction of ﬁrms, markets, in event of their failure. Such a dialogue would and products. Further, it would incentivize risk need to be carried out in conﬁdence between migration and opacity, creating market distor- the ﬁrm and its relevant authorities. Mitigating tions and moral hazard. That said, supervisors actions can then be taken to the degree regulators should take into account the varying degrees deem necessary. of systemic relevance or interconnectedness Any new regulations and the overall new of different ﬁrms in carrying out risk-based regime need to be appropriately differentiated supervision. and risk based. Lines of business such as banking Restricting the size or activities of banks or and insurance can share exposures to similar risks other ﬁnancial ﬁrms will not provide effective and yet exhibit real differences that should be protection against systemic risk, which has been reﬂected in the regulatory approach. triggered by ﬁrms of many different shapes and The IIF’s recently-established Market sizes. More importantly, systemic risk does not Monitoring Group (MMG) is committed to reside in single entities but in the interconnect- identifying and assessing emerging vulnerabilities edness of ﬁrms, markets, and players. Artiﬁcial and potential dynamics in the markets giving rise restrictions on size are likely to produce material to systemic risk, and to dialogue on developments distortions and unmanageable risk patterns of concern with the ofﬁcial sector. within the system. Large institutions play an important role in 5. Improving Market Infrastructure supporting the global economy. They must be and Mitigating Risks of required to meet the highest standards of risk management and corporate governance and Interconnectedness be subject to appropriately intensive risk-based The global ﬁnancial services system has become supervision. They must be subject to meaningful highly interconnected. This has brought many Institute of International Finance • July 2009 ■ 11 beneﬁts—but also brings signiﬁcant risks. The IIF a reinvigorated global economy. Fragmentation regards it as important that measures be put into of the international market would make ﬁnancial place that will retain the beneﬁts of an intercon- stability oversight more difﬁcult to achieve. nected and sophisticated global ﬁnancial system Fighting fragmentation should be a key part while reducing the associated risks. Particular of the FSB’s mandate. Measures should be taken enhancements are needed to ensure the resilience to address the conﬁdence deﬁcit that motivates of the system when facing the failure of a major inward-looking, nationally driven, and uncoor- participant. dinated responses. Signiﬁcantly strengthened For this to be accomplished, it is important frameworks for cross-border crisis management to be clear about what went wrong and what did and ﬁnancial ﬁrm resolution are as important not. Many parts of the system, including equities as regulatory convergence. A non-binding, inter- markets and payment, clearing, and settlement governmental ﬁnancial services accord should be systems, performed robustly. In addition, many established to provide a ﬁrm new footing for derivatives markets, including settlement for cross-border collaboration and conﬁdence. credit derivatives, performed well despite difﬁcult conditions. 7. Cross-Border Crisis Management However, it is necessary to reduce the and Financial Firm Resolution opacity of transactions and of counterparty risk Regimes exposures in the CDS and certain other OTC markets. In line with the commitments already Conﬁdence in the ability of the system to deal made by industry, all eligible standardized effectively with cross-border crises and to transactions should be cleared through a manage the orderly exit of a large cross-border central counterparty (CCP). It is important that ﬁnancial institution is basic. Such conﬁdence, end-users remain able to use these tools to hedge or its absence, has a fundamental impact on the against speciﬁc situations. Accordingly, standard- way ﬁrms and markets are regulated and on how ization should not be pursued to the extent that authorities cooperate in the ongoing supervision it eliminates the ﬂexibility achievable through of international ﬁrms. The FSB should, as a bespoke transactions. priority, develop a convention on cross-border Authorities’ intervention in the area of crisis management. Cross-border crisis simulation market infrastructure needs strong global exercises should be carried out regularly. Burden- coordination. Market infrastructure is highly sharing agreements are needed, based on criteria international in nature, so artiﬁcial distinctions established by the FSB. across borders are likely to invite arbitrage and Authorities should have in place special create market distortion. regimes for bank resolution, including power of early intervention; making the protection of 6. Resisting Fragmentation of the ﬁnancial system a primary objective; and International Markets ensuring alignment with ﬁnancial-markets law (for example, settlement ﬁnality, set-off, and Some responses to the crisis are having a collateral rights). Any winding up of a cross- “fragmenting” effect on the market. An open border ﬁnancial ﬁrm should aim to maximize the question is whether the long-term legacy of outcomes for creditors of the group as a whole the crisis will be protective retrenchment or a without discrimination between creditors by more positive, international regime creating a nationality or location. robust and stable ﬁnancial services platform for 12 ■ Restoring Conﬁdence, Creating Resilience Conclusion Regulation needs to be enhanced in scope, impact, and quality, and should be extended to Effective regulation and effective markets are address systemic stability risk. However, the cost interdependent. Markets in ﬁnancial services of materially misjudged or inefﬁcient regulation must be made to work more effectively than they will have sustained adverse effects. It is essential have previously. Transparency must be improved. that regulatory reform be implemented on the Incentives must be better aligned. Creditors must basis of an integrated regulatory and market be at risk in order to bring a much more effective perspective, a robust assessment of cumulative market discipline to bear. impact, a risk-based approach, international coordination, and effective dialogue. Institute of International Finance • July 2009 ■ 13 Introduction A year ago the IIF published the Final improvements but how to make the structural Report of the IIF Committee on Market and regulatory changes necessary to ensure that Best Practices3 (“Market Best Practices the likelihood of such systemic events in the Report”), which provided a frank analysis of future is signiﬁcantly reduced. the failings and weaknesses in many ﬁrms’ A number of reports have appeared over practices leading up to the recent ﬁnancial recent months addressing the question of how crisis. The Report set out clear and detailed ﬁnancial regulation and market functioning recommendations for ﬁrms’ governance, should be reformed to seek to avoid a recur- business practices, and day-to-day risk rence of the events of the past two years.4 management.4 Taken together, these reports represent a The analysis and recommendations major achievement. Developed over a short contained in the Market Best Practices Report period of time, the reports identify, elaborate, remain centrally important. They support and provide the necessary framework for demonstrated progress and a continuing consideration of most of the central issues to be effort across the industry to reform how determined over the period to come. it does business, including with respect to The present Report seeks to address a corporate governance, risk management, and number of the issues that are raised in those compensation. The IIF membership reafﬁrms reports and are currently under wide consider- its commitment to the implementation of the ation. It attempts neither to be comprehensive recommendations set out in the 2008 report. nor to present detailed views on issues where It is now clear, in light of the traumatic others are better placed to develop the necessary events of the intervening 12 months, that the analysis and propose solutions. Rather, it has roots of the problem were more profound than the objective of putting forward an industry previously had been understood. The question perspective on a relatively few themes where now is not simply how to make necessary decisions made now will have a formative 3Final Report of the IIF Committee on Market Best Practices, July 17, 2008, http://www.iif.com/regulatory/cmbp. 4These include G-20 Declaration on Strengthening the Financial System, April 2, 2009, together with its Working Groups’ reports Enhancing Sound Regulation and Strengthening Transparency, March 25, 2009, and Reinforcing International Cooperation and Promoting Integrity in Financial Markets, March 27, 2009; the Geneva report on the Fundamental Principles of Financial Regulation, July 2, 2009; the Group of Thirty report Financial Reform: A Framework for Financial Stability, January 15, 2009; the report of the de Larosière High-Level Group on Financial Supervision in the EU, February 25, 2009; the Turner Review: A Regulatory Response to the Global Banking Crisis, March 18, 2009; the U.S. Treasury proposals for ﬁnancial regulatory reform A New Foundation: Rebuilding Financial Supervision and Regulation, June 17, 2009; and most recently the UK Treasury document Reforming Financial Markets: Impact Assessment, July 8, 2009. Institute of International Finance • July 2009 ■ 15 impact on global economic well-being for a formal, or bright-line, categories but rather is long time to come. a multifaceted and dynamic concept that must Section 1 considers the beneﬁts of inter- be addressed by comprehensive oversight and national ﬁnancial markets and the importance review at the macrolevel and sophisticated risk- of cross-border coordination and cooperation. based supervision at the microlevel. It argues It reemphasizes the important role of the that seeking to address the problem by artiﬁcial expanded Financial Stability Board (FSB) restrictions on ﬁrms’ size or activities is likely and international standard-setters. It sets out to fail and to do harm, and that instead what the need to take all the measures necessary to is required is a matrix of measures to protect ensure the effectiveness and appropriate consis- against systemic risks. tency of international colleges of supervisors Section 5 addresses systemic issues for cross-border groups. It also identiﬁes the associated with market infrastructure and the need for international solvency standards for high degree of interconnectedness in ﬁnancial insurance ﬁrms. markets. It supports the advances achieved, and Section 2 discusses the shared respon- further commitments made, by the industry sibility of the industry and regulators for in the curtailment of counterparty risk arising achieving high levels of conﬁdence and resil- from credit default swaps (CDS) and other ience in the international ﬁnancial system. It over-the-counter (OTC) markets and in the considers the need for the industry to improve introduction of signiﬁcantly enhanced trans- its practices and the strong progress already parency to support a more-liquid and simpler made, the dual responsibility of ﬁrms and securitization market for the future. It also supervisors to achieve high-quality supervisory draws attention to those important parts of outcomes, the importance of ensuring that the market infrastructure that demonstrated regulation is effective and efﬁcient to maximize considerable resilience during even the deepest social outcomes, and the need for markets to point of the crisis. perform effectively to underpin resilience and Section 6 identiﬁes the growing threat of conﬁdence. This requires that ﬁrms be allowed fragmentation of international markets. It to fail and then exit the market in an orderly notes that to a certain extent this represents a manner. comprehensible reaction by authorities to the Section 3 deals with reform of prudential crisis. However, it calls for a forward-looking and accounting standards, in particular to reinvigoration of international markets and not ensure resilience of the system throughout the a backward-looking retrenchment that will lead economic cycle. Reform and enhancement are to lesser outcomes for all. It suggests ways in necessary across a signiﬁcant number of areas. which this reinvigoration can be achieved. However, it is important that such reform be Section 7 deals with the key topics of cross- well-coordinated internationally, based on a border crisis management and ﬁnancial ﬁrm clear understanding of the likely impact and resolution regimes. To a material extent, the cost, come from an integrated view of all the way with which cross-border crises and bank different moving parts, and remain risk based. failures are dealt determines how international Section 4 considers ﬁnancial stability and coordination and cooperation function during macroprudential oversight. It considers the the ongoing life of a cross-border ﬁnancial thorny question of systemic relevance and services ﬁrm. It is clear that there have been concludes that this cannot be captured by signiﬁcant weaknesses in the way in which 16 ■ Restoring Conﬁdence, Creating Resilience both crisis management and ﬁrm failures have ﬁnancial services and insolvency legislation. The been managed. This is to a signiﬁcant extent due section identiﬁes the need for improvement in to problems deriving from the national basis of these areas and puts forward suggestions. Institute of International Finance • July 2009 ■ 17 SECTION 1 Importance of Coordination in an International Market T he G-20 agreed in London in April “to es- basis for new levels of global economic growth, tablish the much greater consistency and which has delivered improved economic condi- systematic cooperation between countries, tions for many individuals in many countries. and the framework of internationally agreed high Cross-border ﬁnancial groups play a standards, that a global ﬁnancial system requires.” critical role in the efﬁcient allocation of capital. The IIF welcomes this commitment. It is Moreover, during country-speciﬁc crises, the important that ﬁrms be able to operate effectively “internal markets” of cross-border groups have and efﬁciently across borders and to avoid shown themselves helpful to mobilizing resources material regulatory divergence, both jurisdictional in circumstances where external markets may and sectoral. be less available. Therefore, cross-border groups With the great array of regulatory proposals that are able to manage their liquidity and capital that are currently under consideration, it is prudently on a group-wide basis are likely to act essential that authorities carry through with a as a material source of systemic stability. They are strong commitment to coordinate their actions. in a position to leverage the ﬂexibility and resil- ience of the group to deliver liquidity and capital 1.1. BENEFITS OF INTEGRATED where and when it is needed. FINANCIAL MARKETS AND CROSS-BORDER INSTITUTIONS 1.2. POSITIVE STEPS A globalized ﬁnancial system: In line with the commitment of the G-20, much 1. Provides savers and users of funds the progress has been made in the coordination of greatest choice in terms of portfolio cross-border regulatory reform. allocation and ﬁnancing options; The industry warmly welcomes the broadened 2. Enables the efﬁcient transfer of funds mandate of the FSB to include not only assessing from countries with “excess” savings vulnerabilities and promoting coordination and to locations in need of capital for information exchange among authorities respon- investment; and sible for ﬁnancial stability, but also coordination 3. Provides ﬁnancial ﬁrms with the ﬂexibility of international standard-setting bodies, setting to determine the scale, scope, and reach of guidelines for supervisory colleges, and managing their intermediation operations, including contingency planning for cross-border crisis to emerging markets. management. Financial markets play an essential role in An increasingly integrated ﬁnancial market supporting global markets. Strong, sustainable has, over the past 20 years, provided an important growth across the world depends on ﬁnancial markets that are increasingly integrated, regulated Institute of International Finance • July 2009 ■ 19 consistently, and capable of marshaling private balanced sense of priorities from host supervisors. credit for investment needs as they arise. To some extent, this reﬂects the fact that colleges are based purely on good intentions among their 1.3 IMPORTANCE OF COLLEGES participants and lack a clear legal foundation, at least outside the EU, once current proposals are A further welcome decision is the establishment implemented. of colleges of supervisors for all major interna- To achieve the kind of results that the G-20 tional ﬁnancial ﬁrms. The concept of colleges is expects from colleges, the role of the FSB in a powerful one and, properly executed, colleges insisting on coordinated, consistent, and well- working with individual ﬁrms can do a great directed operation by colleges will be essential. deal to advance the goals of coordination and The IIF welcomes the commitment of the FSB, convergence of regulation and cooperation in its press release of June 27, 2009, that it “will among supervisors. Moreover, they can facilitate set guidelines for and oversee the establishment a substantial increase in supervisory efﬁciency and effective functioning of supervisory colleges, as well as effectiveness by aligning the efforts of and will monitor and advise on best practice multiple supervisors; allocating responsibilities in meeting regulatory standards with a view among them; avoiding duplication of effort; to ensure consistency, cooperation and a level developing better and more consistent infor- playing ﬁeld across jurisdictions.” mation for both home and host supervisors about In the medium term, it is likely that the FSB large groups; establishing common reporting and the G-20 will ﬁnd it necessary to request formats and requirements for ﬁrms; coming to that states give their supervisors a clear mandate common decisions about important matters such to act on a basis of international cooperation, as as the Pillar 2 Supervisory Review Process; and well as on the basis of their traditional national assessing overall regulatory effectiveness. mandates, to achieve good results. The G-20 As discussed in Section 4, well-functioning took a step in this direction by agreeing that all colleges of supervision can also play an important regulatory authorities ought to have a ﬁnancial role in implementing the microprudential aspects stability mandate; a similarly agreed mandate of macroprudential oversight. for international cooperation would make Parts of the G-20 mandate implicitly expand sense. the remit of colleges. For example, supervision of liquidity risk management in large ﬁrms will Commitment I: The IIF membership will certainly need to be coordinated through colleges. dedicate the necessary resources and engage On their side, ﬁrms need to dedicate resources with their colleges of supervisors on a high- and ensure they engage with their colleges on priority, fully committed basis. a fully committed basis. Yet effectiveness is a two-way street. Firms’ investment of time and Recommendation 1: The FSB should proceed resources in working with colleges depends on quickly and with continued determination in making the productivity of the process fully taking the steps necessary for the establishment evident. Here, it must be recognized that ﬁrms’ and operation of well-functioning colleges experiences with colleges previously organized for of supervisors for internationally active Basel II purposes has been decidedly mixed. Some banks. Ensuring effectiveness, high-quality have usefully increased supervisory efﬁciency, cooperation, and appropriate consistency in clarity, and consistency, but this has not always the operation of these colleges should be a been the case. high-priority task for the FSB and supervisory Colleges impose a signiﬁcant burden on the authorities. home supervisor and require cooperation and a 20 ■ Restoring Conﬁdence, Creating Resilience 1.4 ENHANCED SIGNIFICANCE OF Added Roles of the International INTERNATIONAL STANDARD- Organization of Securities Commissions SETTERS The crisis has raised issues of market and conduct-of-business regulation as well as The new role of the FSB does not diminish, and prudential regulation. The International Organi- indeed should enhance, the importance of the zation of Securities Commissions (IOSCO) has role of the Basel Committee and other standard- done ﬁne work over the years in developing setters that participate in the FSB. Their task internationally recognized standards for securities becomes more important—and more complex— regulation as well as effective models for cooper- because of their expansion to include additional ation on information sharing and enforcement. major economies, but the substantive importance As it has become clear that market regulation of their tasks is all the more important as well. has an effect on systemic stability as well as Achievement of convergence and consistency, at a prudential regulation and solvency requirements, practical as well as a theoretical level, is essential the role of IOSCO will necessarily grow. to a well-functioning future ﬁnancial system that Matters such as hedge fund regulation, will be free of regulatory arbitrage and unfair regulation of credit-rating agencies, product anomalies or vulnerability-creating loopholes. transparency, and the like all too easily lead to national deviations or are based on as-yet unrec- Basel Committee Leadership onciled national traditions. The recent experience As the discussions of capital and related matters with uncoordinated short-selling regulations in Section 3 make clear, the Basel II Accord shows clearly the need for international coordi- remains absolutely essential to the future nation in the securities sector, a need IOSCO fully soundness of ﬁrms and the resilience of the recognizes. system. Getting the planned changes right is of In addition to attending to speciﬁc regulatory the greatest importance, as is the need for timely issues, IOSCO has the opportunity to contribute and consistent implementation of the Accord to enhanced cross-border cooperation. across all major jurisdictions, including the In particular, the IIF welcomes the recent United States. It will be most important if the statement of Jane Diplock, Chair of its Executive G-20’s coordination mandate is to be carried out Committee, calling for the renewal of discus- for the Basel Committee to maintain leadership sions on mutual recognition between securities on capital, leverage, and similar issues. authorities as well as the Committee of European Substantively, the international consistency Securities Regulators’ (CESR) consultation paper and level playing ﬁeld that only the Basel on the topic.5 Committee can achieve will be absolutely essential to international stability. The origins of the Basel process show incontrovertibly the dangers of international capital divergence. As discussed further in Section 6, those dangers are today real. Keeping the Basel Committee in the lead on these processes—and avoiding front- 5 Jane Diplock, Speech at Centre for European running by individual jurisdictions that may Policy Studies, Brussels, April 22, 2009; CESR: Call become impatient with the process—will be one for Evidence on Mutual Recognition With Non-EU of the FSB’s and G-20’s most important tasks. Jurisdictions, June 8, 2009. Institute of International Finance • July 2009 ■ 21 essential. Therefore, current efforts on regulatory Recommendation 2: National authorities reform should give impetus to the development should coordinate closely in respect of the wide of an international regulatory standard on array of regulatory proposals that are currently solvency for insurance companies, which could under consideration, working through the be based on the original proposals for the EU relevant international standard-setting bodies. Solvency II directive (including strong group- Such coordination should go beyond the level supervision provisions). of principle or direction and ensure consistency The International Association of Insurance of speciﬁc regulation. There should be timely Supervisors (IAIS) is well placed to take up this and consistent global implementation of Basel task provided that there is commitment from II, appropriately modiﬁed. Coordination all major jurisdictions. The IIF membership becomes increasingly important given emerging is committed to playing a responsible and fragmentation. constructive part in this dialogue. Recommendation 3: A global framework for the supervision and regulation of 1.5. TIME TO MOVE TO internationally active insurance ﬁrms on a INTERNATIONAL SOLVENCY group-wide basis should be developed under STANDARDS FOR INSURANCE the leadership of the IAIS. While it is evident and reasonable that insurance regulation has not been an area of focus during the crisis, this does not mean that policymakers 1.6. TROUBLING DEVELOPMENTS should miss this opportunity to address what is perhaps the key priority area on insurance The G-20 stated in London that any retreat regulation: a global standard for the supervision into ﬁnancial protectionism, and in particular and regulation of internationally active insurance measures that constrain worldwide capital ﬂows, groups on a group-wide basis. should be avoided. Unfortunately, recent months In this Report we have analyzed in detail the have seen a growing number of measures, the issue of how to promote an effective framework effect of which is to cause fragmentation of the for the supervision of internationally active international market along national boundaries.6 ﬁnancial ﬁrms. In insurance, despite the efforts by The attachment of explicit or implicit a number of jurisdictions to organize meaningful domestic lending requirements to government colleges for international ﬁrms, the results have assistance betrays a strong and troubling tendency been less than optimal. Without a common to home bias. Measures based on self-sufﬁciency framework, efforts by supervisors from different concepts designed to increase the protection of jurisdictions are focused on their own territories, domestic stakeholders even though the effects and much remains to be done to develop a on the global system are negative are equally comprehensive, meaningful, and effective super- troubling. This issue of fragmentation is discussed visory arrangement for an international insurer. in more detail in Section 6. Insurance supervisors continue to work 6 For a more detailed elaboration of different through a patchwork of different regulatory systems. This situation ought to change. The fragmenting measures of recent months, see recent ﬁnancial crisis has made it evident that truly IIF Staff Paper, Fragmentation of the Financial System: Analysis and Recommendations, June 11, 2009, http:// international approaches to regulation are www.iif.com/regulatory/article+363.php. 22 ■ Restoring Conﬁdence, Creating Resilience 1.7. NEED FOR WITHDRAWAL as discussed further in the Market Best Practices STRATEGIES Report, it will be important to design rather broader, more-uniform collateral and other While government interventions to secure policies for the central banks’ regular role in stability over the recent period have been money markets in the new regime. Formalizing welcome and important, it is necessary now to emergency liquidity and collateral policies for develop withdrawal strategies for governments future use should also be part of the withdrawal to exit their holdings in ﬁnancial ﬁrms. Well- process. formulated and executed plans in this regard are It will be important for both normal and essential to avoid competitive distortions and emergency policies to be internationally harmo- ensure a level playing ﬁeld both within and across nized and coordinated to the maximum extent countries and to restore an effectively functioning possible. Deﬁnition of new central bank policies marketplace. will require reconsideration of the appropriate Such plans should take into account not only degree of “constructive clarity” regarding central the time frame for reducing budget deﬁcits but bank roles in markets—a critical aspect of also the need to deal with looming pension and systemic stability—while also conserving an health care problems. Failure to present credible appropriate degree of “constructive ambiguity” withdrawal strategies in a timely and convincing concerning lender-of-last-resort measures for manner could add to the currently rising volatility individual ﬁrms that fall into difﬁculties (see of interest rates and government bond yields, Market Best Practices Report, pp. 58–62). hurting the chances of global economic recovery. Public-sector withdrawal strategies need to Recommendation 4: Clear strategies include consideration by the central banks of the should be developed for the withdrawal transition back from the exceptional facilities put of governments from ownership positions in place during the crisis to support markets and in ﬁnancial institutions and for ending to provide liquidity support to money markets. extraordinary liquidity and market support This will require deﬁning a “new normal” state of measures. Such strategies should be carefully central bank liquidity facilities that will certainly coordinated internationally to be fully effective not be identical to the exceptional facilities of the and minimize the risk of unanticipated past year. The new normal will also most likely consequences. not be identical to the status quo ante 2007 and, Institute of International Finance • July 2009 ■ 23 SECTION 2 A Shared Responsibility to Achieve Resilience T he G-20’s Working Group 1 said that the evaluate internal policies, processes, and proce- objective of regulatory reform is to build a dures against the recommendations of the Report. ﬁnancial system that will support growth The IIF also has organized knowledge-sharing and rising living standards across the globe while meetings among member ﬁrms to allow them to reducing the risk of ﬁnancial instability. 7 It share their experiences of self-assessment. notes that ﬁnancial crises have very large social Member ﬁrms in major markets have costs. At the same time there are large social ben- reported that they have concluded gap analysis eﬁts to all from a dynamic and efﬁcient ﬁnancial against the IIF Recommendations and parallel system that transforms savings into productive recommendations (for banks) of the Senior investments and helps households and businesses Supervisors Group and other groups. This manage risks. analysis has indicated in general a good deal Building and maintaining a high degree of of progress regarding implementation of the resilience in ﬁnancial markets, while ensuring Recommendations. Firms are in the process of that excessive caution does not overwhelm remedying identiﬁed shortcomings, most of efﬁciency and innovation, stiﬂing future growth, which will be addressed by the end of 2009. depends on the effective interaction of markets and regulation and on the quality and success 2.1. RISK MANAGEMENT— of the relationship between authorities and A SECULAR CHANGE IN ﬁrms. Achieving ﬁnancial stability is a shared PROGRESS responsibility. The IIF’s Market Best Practices Report was Signiﬁcant progress is being made by ﬁrms to published in July 2008. It detailed the wide address the weaknesses identiﬁed in the Market range of weaknesses and vulnerabilities in ﬁrms’ Best Practices Report and by regulators. business practices that contributed to the devel- Work on risk management goes beyond opment of the crisis. It set out a large number of simple improvements. Rather, a step change recommendations for change. in ﬁrms’ approaches to risk management is Since then, there has been an active dialogue starting to be evident. This is essential as strong among IIF members to assess implementation risk management is the ﬁrst line of defense in of recommendations of the Report. To facilitate ensuring the soundness of ﬁrms. Reforms include the process, the IIF has made available a model the following: methodology for self-assessment, which provides a framework through which members can Improvement in the governance of risk management, with revised responsibilities 7G-20 Working Group 1: Enhancing sound regulation and oversight functions of senior manage- and strengthening transparency, March 25, 2009. ments and boards; Institute of International Finance • July 2009 ■ 25 At some ﬁrms, an overhaul and compre- stock of implementation and formulating an hensive revamping of the risk systems and updated view of the issues raised in the Market infrastructure, including personnel decisions Best Practices Report. This upcoming report will aimed at bringing in top talent to guide these summarize the state of the industry, highlighting efforts; changes and improvements in the industry’s Making more robust the process of deﬁning landscape since the release of the Market Best and enforcing the ﬁrm’s risk appetite; Practices Report in July 2008 and identifying Especially in highly affected ﬁrms, open issues that still need to be addressed by consciously addressing deﬁciencies of risk the industry or regulators. It also will provide culture; additional recommendations on a number of Revision and improvement of internal matters related to risk management. risk models, with particular emphasis on Value at Risk (VaR) and understanding and Commitment II: The IIF membership will as a managing its limitations to assess risk during matter of ﬁrst-order priority continue the good times of economic stress; progress to bring their risk management and Investment in risk-related information other business practices into alignment with the technology, including quicker and more recommendations of the Market Best Practices reliable aggregation capabilities; Report. Signiﬁcant improvement in stress-testing Commitment III: The standards set out techniques and capabilities, including in the Market Best Practices Report have approaches to develop ﬁrm-wide views on become a benchmark for large, internationally the impact of adverse economic scenarios; active ﬁrms. The industry welcomes the use Enhanced liquidity management, including of this and other reports, such as the Senior adequate internal pricing of liquidity to Supervisors Group Report of March 6, 2008, avoid “free lunch” use of liquidity, as well as in the supervisory assessment of the quality of increased liquidity buffers; risk management of such ﬁrms. Increased capital in many ﬁrms (in response to market and ofﬁcial demand); Substantially improved valuation, especially of less-liquid assets, assisted by method- Compensation ological improvements and improved Early in the crisis, industry bodies recognized external pricing infrastructure; that mismanaged compensation incentives were Enhanced accounting, in line with evolving a factor in the build-up of risk within ﬁrms, guidance by the standard-setters; and thereby contributing to market instability. The Greatly enhanced transparency in securi- IIF’s 2008 Market Best Practices Report set out tization businesses, thanks in large part to seven Principles of Conduct to guide the industry industry initiative as well as enhanced in its restructuring of compensation practices. By Pillar 3 transparency on risk management. way of follow-up, the IIF conducted an industry survey of the status of compensation reform In addition, the IIF is developing a report earlier this year. The survey results, published in (to be issued in late November 2009) taking collaboration with the management consultants 26 ■ Restoring Conﬁdence, Creating Resilience Oliver Wyman in March 2009,8 were widely disseminated and shared with key regulators. Commitment IV: The industry is committed The survey showed that while much progress to continue to implement reforms in has been achieved, further work remained to be compensation practices so as to align done, including on the adjustment of perfor- these practices with the IIF Principles and mance compensation to the time horizon of risk recommended leading practices, as well as and the cost of capital and on the governance of with the FSB Principles. In this regard, compensation within ﬁrms. The survey results the IIF intends to monitor developments in also helped crystallize a set of recommended industry practices and to provide an informal leading practices which further amplify and assessment in the forthcoming report of the enhance the seven Principles of Conduct of the IIF Steering Committee on Implementation earlier report. in November 2009 and to conduct a survey of Since early this year, the FSB has issued industry practices in 2010. Principles for Sound Compensation Practices9 Recommendation 5: Regulatory authorities while several national authorities have also issued should develop appropriate supervisory guidelines providing a broad framework for guidelines on compensation, in line with the the governance of compensation policies and FSB Principles, in a timely manner so as to approaches to their supervision. The ﬁnancial reduce market uncertainty. The FSB should services industry has generally welcomed the ensure that these guidelines are consistent, principles-based approach set out in the ofﬁcial in all important respects, across jurisdictions statements, which are broadly consistent with and that a reformed regulatory environment the IIF principles and recommended leading also provides for a level playing ﬁeld on practices. compensation between the regulated and The industry is determined to proceed with non-regulated segments of the ﬁnancial ongoing reforms in this critical area to ensure that market. industry practices are aligned with the core IIF principles and leading practices as well as with FSB principles. Securitization 8 Compensation in Financial Services: Industry Progress One frequently cited cause of the crisis was the and the Agenda for Change, March 30, 2009, http:// precipitous decline in value of many complex www.iif.com/press/press+101.php. securitizations. At the same time, securitization 9 April 2, 2009. as a broad asset category served major markets extremely well for many years prior to mid-2007. Securitization of credit card receivables, student loans, automobile loans, and “vanilla” or standard mortgages was an essential source of credit for the real economy. To achieve a robust recovery, such securitization needs to return to a signiﬁcant role in credit generation. As discussed further in Sub-section 3.1 and Section 5, where structures are not complex, assets are well understood, underlying lending standards are maintained, and adequate trans- Institute of International Finance • July 2009 ■ 27 parency of the underlying assets exists, vanilla and supervision work successfully as it is on the securitizations have been relatively resilient even ofﬁcial sector. in difﬁcult markets. Bank balance sheets will certainly not be High-Quality, Critical Analysis and Receptive able to replace credit securitization as it has Engagement by Firms been provided in recent decades. Rather, simpler Strong and effective supervisory engagement structures based on good underwriting standards, between ﬁrms and supervisors depends on a well-understood assets, and ongoing transparency mutual commitment to a dynamic, high-quality are the answer. dialogue of critique and challenge. There are several dimensions to achieving This commitment requires that the industry this. These include uniform, high standards of engage positively and non-defensively with underwriting; better analysis by institutional supervisors. This is by no means an easy investors; and ratings reform, as discussed in challenge, as proﬁt and loss are at stake. Success Section D.V of the Market Best Practices Report. depends on the creation of appropriate incen- These issues are being addressed by ﬁrms in tives for personnel and the creation of a strongly the market, by the rating agencies, and by the supportive culture within the ﬁrm. regulators, especially with respect to standards The more-intense supervisory engagement applicable to origination of the underlying advocated by many as a lesson learned of the lending, in particular mortgages. crisis clearly requires a large number of highly Nothing is more essential than providing qualiﬁed supervisors, appropriately resourced ongoing transparency as to the assets underlying to develop strong analysis, and with levels of securitizations and, as mentioned in more detail seniority and authority to engage ﬁrms in a in Section 5, the product specialist associations strong, critical, and analytical dialogue. in the securitization sphere have made very signiﬁcant strides to improve availability to the An Improved Culture market of information on underlying assets and overall documentation. The cultural response to supervisory intervention Taken together, all these changes, when differs across ﬁrms. In some, it is mature and complete, will provide a solid basis for the healthy. In others, it is less so. return of widespread use of the kinds of simple, It is necessary that ﬁrms take engagement transparent securitizations that will ensure a with supervisors not as a necessary evil but as renewed ﬂow of credit to important consumer essential to normal management. Engaging sectors while avoiding recent excesses, subject to constructively with supervisors can be a valuable regulatory and accounting changes as discussed in process for continual improvement of products Section 3. and returns to shareholders, as well as a means to reduce ﬁnancial, legal, and reputation risk. 2.2. EFFECTIVE SUPERVISION IS A Work being carried out by the IIF suggests TWO-WAY PROCESS not only that speciﬁc cultural traits are critical to healthy risk management within a ﬁrm but also Successful regulation and supervision, like that it is possible to implement speciﬁc measures successful policing, is highly dependent on to foster a positive risk culture within a relatively the attitude and approach of the community short period of time. This is an area of important being regulated and supervised. It is as much continuing work. The IIF will publish the results incumbent on the industry to make regulation of its work in this area in the November report mentioned above. 28 ■ Restoring Conﬁdence, Creating Resilience Many ﬁrms have been actively addressing Putting the focus on management judgment, internal cultural issues uncovered by the crisis, as opposed to reliance on a few numbers from and all ﬁrms should take the steps necessary to risk management systems or ticking regulatory create a sound risk culture in accordance with boxes, puts more, not less, pressure on manage- the recommendations of the 2008 Market Best ment to act prudently in accordance with the Practices Report. ﬁrm’s articulated risk appetite. It also puts more pressure on supervisors to evaluate the substance Setting Clear Principles and Holding and quality of a ﬁrm’s risk management as Firms to Them opposed to formal compliance. Among the fundamental lessons of the The IIF has long been supportive of outcomes- crisis are that risk systems are of little avail if focused regulatory approaches that rely to a not used critically and with good judgment by large but well-considered extent on principles, as management and that supervisory challenges must opposed to over-reliance on detailed rules. As was go beyond looking at numbers and checking that said in the 2006 Proposal for a Strategic Dialogue rules are not transgressed. As the 2006 Proposal on Effective Regulation,10 “at a general level, the acknowledged, principles-based regulation is IIF is supportive of ‘principles-based’ regulation, in fact harder for all concerned, but the crisis but is realistic about what this entails. Principles- demonstrates that good judgment measured based regulation requires more dialogue, greater against actual outcomes is the bottom line of willingness by regulators to make and stand success for both management and supervisors. by judgments of what constitutes acceptable compliance, and readiness by ﬁrms to accept Providing Risk-Based Supervision those judgments.” There will always be a need for a material Risk-based approaches to supervision will be rules-based component of ﬁnancial regulation. essential to achieving desired objectives for the However, this should never be allowed to give rise future. While important before, these approaches to a tick-box mentality in which formal adherence become of even greater signiﬁcance in light of the to rules outweighs thoughtful compliance with recognized need for an enhanced supervisory role sound principles. All participants—in ﬁrms in respect of risk to ﬁnancial stability. and authorities—should act on a strong under- The industry accepts that to the extent that standing of relevant activities and products and risks are greater, the intensity of supervision of their risks, using good judgment on the basis of should increase. It sounds a note of caution, and constrained by rigorous principles. however, for all to be watchful for the potential What is needed, accordingly, is an approach for unintended consequences if the new require- that strives for a good balance and well- ments cause risks to migrate to less-regulated considered interaction between principles and parts of the system, where they are more difﬁcult rules. This balance should seek to maximize to identify and manage. resilience by prioritizing the use of analytical judgment across the system and to optimize Aligning Incentives the alignment of incentives toward efﬁciently The correction of procyclical tendencies in the prudent industry behavior and clearly understood current Pillar 1 of Basel II mandated by the G-20 regulatory outcomes. and discussed further below at Sub-section 3.2 10 will come at a cost. A full analysis of the actual Proposal for a Strategic Dialogue on Effective extent of the procyclicality of the Accord is still Regulation, December 13, 2006, http://www.iif.com/ regulatory/effreg. needed, but it is possible that the new regime Institute of International Finance • July 2009 ■ 29 may be less sensitive to risk. As we have seen in analysis into effective oversight and micropru- the past, non-risk-sensitive capital requirements dential action creates signiﬁcant new challenges can pose or amplify systemic risks. Perverse for supervision. As an international consensus incentives set by non-risk-sensitive capital on the scope, goals, and modalities of macro- requirements under Basel I have been among the prudential scrutiny of market and economic root causes of this crisis, and there is the danger developments still needs to be developed, so too of similar problems’ emerging depending on do the means of implementation. International how cyclicality is addressed and if overly rigid consistency on the goals and means of implemen- measures are introduced on leverage (discussed tation of the new mandate for macroprudential in Sub-section 3.4). oversight will be essential to avoid competitive Appropriate incentives will need to be and even economic distortions. A sophisticated, provided through Pillar 2 enforcement tools. risk-based, outcomes-focused approach to Capital add-ons are the primary tool for setting incorporating macroprudential inputs into incentives under Pillar 2 and should be subject microprudential supervision based on continuous to a balanced system of surcharges and discounts improvement of internal risk management will be reﬂecting the full range of ﬁndings from super- a necessity. visory scrutiny. In addition, there are further More sophisticated microprudential super- options for tangible reward and penalty reﬂecting vision will need to be complemented by effective an institution’s record under the Pillar 2 review feedback from the microprudential level to and evaluation: macroprudential oversight. The macroprudential Well in line with the logic of a risk-based process will be most effective if it uses bottom-up approach to microprudential supervision, an insights from supervisors and colleges as well as institution’s Pillar 2 record should drive the top-down macroeconomic analysis. To achieve frequency and intensity of the supervisory this, a new dimension of horizontal, thematic review and evaluation process. work across peer groups of institutions and across An institution’s Pillar 2 record also should jurisdictions will be necessary. inform the size of qualitative adjustments The microprudential implementation of applied under the advanced measurement macroprudential oversight and analysis will approach to operational risk. make the demands on supervisors all the more Increasing microprudential supervision challenging. The proper calibration of capital will be costly, and a signiﬁcant escalation add-ons, supervisory directions regarding the in supervisory fees assigned to the industry countercyclical draw-down or build-up of can be expected in the relevant jurisdictions. additional risk buffers, and supervisory measures Here as well, risk- and incentives-based to remedy identiﬁed deﬁciencies of broader criteria should and can be easily combined market practices will require robust risk analysis to develop a fee allocation formula that and difﬁcult judgment calls when translating the rewards or penalizes as appropriate an analysis into supervisory action. institution’s behavior. The implications are obvious. In addition to the general need for enhanced capability, micro- Microprudential Implementation of prudential supervision will require signiﬁcantly Macroprudential Oversight and Analysis more resources, broader expertise, and a wider set of skills. In order to help identify systemic As discussed in Sub-section 4.4, a very important vulnerabilities and cyclical risks they will have to aspect of the new framework will be the focus on develop a deeper understanding of institutions’ systemic risk. The translation of macroprudential 30 ■ Restoring Conﬁdence, Creating Resilience businesses and business models, of their risk A “market-failure” based approach to measurement and management practices, of regulation is sensible and by now well grounded their governance, and of the national and global in extensive academic and supervisory literature. markets in which they are operating. Regulation usually is justiﬁed where necessary to achieve better outcomes than could be achieved Commitment V: The IIF membership will by participants left to themselves. undertake the efforts and investment necessary Market-failure analysis should remain the to promote the success of more outcomes- basic justifying premise for ﬁnancial regulation. focused, judgment-based supervision. This At the same time, we do not believe that the use will include developing standards and norms of market-failure analysis should become unduly of behavior to underpin a better quality of narrow or trapped in the application of overly relationship with supervisors. rigid econometric techniques designed to prove or quantify market failure. Such techniques can Recommendation 6: Authorities should be useful as a point of reference but should not continue to develop a more consistently detract from the need to make sound, whole- outcomes-focused, judgment-based approach to picture judgments as to whether or not markets regulation. The IIF recommends increasing the need assistance in delivering desired outcomes. resources, expertise, and skills of supervisors to implement macroprudential oversight. Understanding Impacts, Weighing Beneﬁts Any debate as to the need for speciﬁc regula- tions needs a robust understanding of the likely 2.3. MAKING REGULATION impact in terms of incentives, costs, and expected EFFECTIVE beneﬁts. This has been a long-standing view of A Robust Approach to Developing Financial the IIF12 and remains equally valid today. Regulation However, it does not always add to the quality of the discussion to try to put precise monetary There has been growing agreement between values on the impacts or potential implications policymakers and industry participants on the of different regulatory proposals. Trying to attach merits of an integrated approach to developing monetary values to impacts that often are diffuse effective regulation.11 The process consists and long-term, so as to make them meaningfully broadly of the following: weighable against the putative beneﬁts, can in 1. Problem identiﬁcation and market- certain circumstances undermine the importance failure analysis; of high-quality impact analysis. As we said in our 2. Deﬁnition of objectives; 2006 Proposal, “costs and beneﬁts are often hard 3. Development of policy options and impact to quantify, and impacts should not be assessed assessment; solely or even primarily on the basis of narrow 4. Consultation with stakeholders; efforts at quantiﬁcation.” 5. Policy decision; and High-quality impact analysis, taking into 6. Review once the policy has been account the effects of proposals on the overall implemented and enforced. efﬁciency of the system as well as effects on individual ﬁrms, remains essential to achieving effective and efﬁcient regulation. It is of the 11See, for example, European Commission, Impact Assessment Guidelines, January 2009; CESR–CEBS– 12See A Proposal for a Strategic Dialogue on Effective CEIOPS, Impact Assessment Guidelines, April 2008. Regulation. Institute of International Finance • July 2009 ■ 31 utmost importance that the potential impact be assessed rigorously and having regard to the Recommendation 7: It is essential that best data and information that is reasonably regulation be effective while ensuring that practicably achievable. These impacts then are markets remain as efﬁcient as possible. The effectively weighed against the beneﬁts likely to be principles of effective regulation should be achieved. followed, including: Clearly identiﬁed objectives; Incentives-Directed Regulation Clear understanding of impacts, both It is important that regulation be based as much positive and negative (but avoiding as possible on engagement with market incen- mechanistic or purely quantitative tives. To lever the incentives of ﬁrm management methods); is likely to be both more effective and more An incentives-focused methodology; and efﬁcient than simply to impose requirements. Incorporation of consultation and dialogue. To give an example, an approach that rewards strong and effective risk management within a ﬁrm is likely to produce much better results in Dialogue on Effective Regulation the long run than an approach that prescribes separate sets of requirements that become a pure One aim of the IIF’s 2006 Proposal on effective compliance exercise divorced from the way the regulation was “to establish an ongoing, strategic ﬁrm is run. dialogue between the two groups, focused on a clearer appreciation of common goals, effective Appropriate Differentiation and efﬁcient regulatory approaches, and methods by which these objectives can best be achieved.” Reﬂecting a risk-based approach, the revised In view of recent events and of the scale of the regulatory framework should be appropriately challenge that lies ahead, there would be consid- differentiated. Similar activities, such as banking erable merit in taking this proposal forward at and insurance, can share similar risks and, at the this stage. The FSB recently has been expanded same time, exhibit real differences that should be and provided with a considerably enhanced reﬂected in the regulatory approach. mandate. It has announced the establishment For example, insurers are primarily funded by of a Standing Committee for Supervisory and advance premium payments, which in most cases Regulatory Cooperation. cannot be withdrawn on demand or prematurely The next step is to establish a mechanism for (exceptions are certain life insurance policies). structured dialogue between the FSB and industry This means that the different liquidity proﬁle representatives to focus on the achievement of of insurance business should be recognized. effective regulation during the period immedi- Similarly, recognition must be given to the ately ahead, when resolution of the crisis will different nature of insurance risks, which tend create the opportunities to improve the regulatory not to be correlated with market risk. architecture substantially. The FSB is uniquely placed to ensure that the dialogue transcends the traditional sectoral boundaries within the ﬁnancial services industry—banking, securities, and insurance—and the traditional allocations of responsibilities between prudential conduct of business and market regulators, while also taking on board the new macroprudential perspectives. 32 ■ Restoring Conﬁdence, Creating Resilience ishing risk taking, but only at signiﬁcant cost to Recommendation 8: There should be a credit availability and economic performance. structured, ongoing dialogue between the To achieve meaningful market discipline, it FSB, the standard-setters, and the industry is important that creditors other than protected to support high-quality, effective, and well- depositors or policyholders be at real risk of coordinated international regulatory reform. loss in the event of the failure of a ﬁrm. Absent This should cover all ﬁnancial sectors and all perceived risk of loss, risks will be taken on the types of regulation (prudential and conduct of assumption that ultimately the taxpayers will bear business). such loss. Two Complementary Paths 2.4. RELYING ON MARKETS TO The belief that ﬁrms were too big or too intercon- ACHIEVE STABILITY nected to be allowed to fail with loss to creditors appears to have been prevalent during the recent A central question in the development of the new period. Accordingly, the level of discipline was international regulatory framework is the extent reduced. to which—in light of the events of the past two Two complementary types of effort are years—markets can be relied on generally to tend needed. toward ﬁnancial stability. To the extent that this On the one hand, as discussed above, it is is not the case, regulation is more necessary to necessary that regulation and supervision be protect the system against damage. enhanced to ensure these risks are better under- The case for signiﬁcantly reduced reliance on stood by the community as a whole and better markets is made succinctly in the Turner Review, addressed at both microprudential and macro- one of several voices calling into question the prudential levels. “efﬁcient market” theories of the past 30 years. On the other hand, there should be strong It contends that there are increasingly effective incentives so that investors—in particular, criticisms that markets cannot be relied on, that creditors with limited share in the upside of the rationality of individual actors’ pursuing their the risk taking—take action to reward prudent own goals does not ensure collective rationality, behavior and penalize undue risk taking. Market and that individual behavior is in any event not discipline failed in many cases to operate entirely rational. effectively in the period leading up to the It has long been recognized that markets crisis. Accordingly, in addition to developing a have important failings. One key failure is that framework of enhanced regulation, an essential participants can be expected to manage their risks focus of effort should be to ensure that market effectively up to the point where the cost of doing discipline operates much more effectively for the so makes sense from their own point of view. future. To the extent that costs are necessary to protect others, markets do not reward or incentivize ﬁrms Financial Firm Failure and Resolution to do so. Frameworks Equally, regulation has its limits. As Gary Stern, President of the Federal Reserve Bank of To increase the perceived chance that a signiﬁcant Minneapolis, has noted, an approach that relies ﬁrm will be able to exit the market in an unduly on regulation at the expense of market orderly manner, signiﬁcant enhancement of discipline could conceivably succeed in dimin- international regimes for dealing with failing institutions should be a top priority. Means need Institute of International Finance • July 2009 ■ 33 to be developed for early intervention in, and pants generally to achieve high levels of trans- the orderly winding-up of, such institutions in parency to support an effective market discipline such a manner as not to cause undue damage regime. to the overall system while allowing losses to be borne by creditors in line with applicable rules Other Means to Increase Market Discipline concerning priorities in insolvency proceedings. There may be other means available to increase This issue is discussed at length in Section 7. overall levels of market discipline in the system. The changes outlined there are essential to the As part of the reform process, the industry operation of strong market discipline for the as well as the ofﬁcial sector should give close future and thus to the success of the revised consideration to all possible ways of increasing regulatory framework. the effectiveness of market discipline. The greater Making it possible for a major ﬁrm to exit the extent to which this can be achieved, the the market without causing severe disruption to sounder and more efﬁcient will be the system, the the entire system also will require considerable less intrusive the necessary regulation, and the further attention to how to ameliorate the risks lower the ultimate risk to ﬁscal authorities and arising from the high degree of interconnect- taxpayers. edness of ﬁrms in the ﬁnancial system without In addition, the orderly withdrawal of diminishing the substantial beneﬁts that intercon- extraordinary state support of ﬁrms and markets nectedness produces. We consider these issues in discussed in Sub-section 1.7 should be conducted more detail in Section 5. with the reinvigoration of market discipline as one of its principal goals. Transparency Another reason why market discipline failed to Recommendation 9: Resilience depends in operate was that there was insufﬁcient trans- large part on the risk management of ﬁrms and parency of critical products and activities, for the functioning of markets. Regulation cannot example, in respect to the underlying assets of do the job on its own. It is essential to restore structured products and their riskiness and to and enhance market discipline, in particular by the risk proﬁles of counterparties. The industry ensuring that creditors of ﬁnancial institutions fully agrees that levels of meaningful transparency (other than depositors and insurance policy- need to be signiﬁcantly increased.13 This issue holders, and subject to the rules of priority in is discussed in more detail in Section 5. Much insolvency) are at risk of appropriate loss in has already been done, and more is under way. the event of failure. Reform should lever and However, it will be necessary to review further seek to enhance the positive dynamic between whether this achieves everything that is necessary markets operating under effective discipline to ensure effective market discipline. and more effective regulation. The industry is committed to continue to work with the ofﬁcial sector and market partici- 13 See Market Best Practices Report, Section D.VI. 34 ■ Restoring Conﬁdence, Creating Resilience SECTION 3 Achieving Resilience Through the Cycle With Prudential and Accounting Standards I n this section, we provide an industry view of the insurance business also need to be weighed on what is required to enhance the role carefully, and hasty conclusions should be capital and liquidity requirements and ac- avoided. counting standards play in absorbing market and systemic shocks. Experience shows that current Need for Enhancement requirements need to be better adapted to times It is widely agreed that levels of capital in many of stress or economic downturn. In particular, parts of the system leading up to the crisis were measures need to be taken to reduce procyclical- insufﬁcient, and a risk-based increase in such ity. The overall outcome should be to ensure that capital is necessary. The analysis must focus on protection is available when most needed. how to determine reasonable levels of capital that serve the purposes of ongoing resilience of the 3.1. REGULATORY CAPITAL ISSUES system against future shocks but also underpin Capital adequacy is a central issue being sustainable credit provision. considered as the industry and the regulatory Quantity is, of course, not the only dimension community ponder fundamental changes in the to be considered. The quality of capital (avail- global ﬁnancial regulatory framework. Assuring ability and loss absorption capacity), the adequate adequate capital requirements and the necessary control of leverage, and the management of shock absorption capacity without stiﬂing credit cyclical volatility of capital all must be addressed generation is a tremendous challenge and requires in order to achieve a comprehensive framework an informed debate about the level of stress for ﬁnancial institutions’ capital. capital should insure against. In achieving the Enhanced capital regulation must be globally right balance it is fundamental to get the capital consistent to ensure a level playing ﬁeld and foundation right. At the same time, it is necessary avoid competitive distortions. This is certainly to keep in mind that capital is not a panacea for recognized in the Basel Committee’s agenda and all problems; liquidity buffers, good management, several of the regulatory proposals recently issued rigorous risk management, robust corporate including the Turner Review and the recent U.S. governance, and strengthened supervision all Treasury proposals. have important roles to play. This discussion follows most of the debate in Clear Objectives the wake of the crisis in focusing on capital for The consensus as to the need to reform overall banks and investment ﬁrms. It should be kept capital in the system has so far left unanswered in mind that, while crisis issues need to be taken the questions of how to achieve an appropriate into account in making policy decisions as to increase, the allocation of any increase across parallel insurance requirements, the speciﬁcities Institute of International Finance • July 2009 ■ 35 risks and businesses and, indeed, the actual risk management practices through additional goals intended to be reached, beyond a general Pillar 2 guidance (addressing fundamental issues desire for greater stability. Clarity as to goals at such as adequate stress testing, management a somewhat more precise level is important. A of risk concentrations, and ﬁrm-wide risk “zero failure” objective would be ultimately highly management) will reinforce on a consistent basis damaging and must be resisted. Getting the levels the work being done by ﬁrms to improve internal right will not be easy. As has been made evident risk management. in the case of the trading book capital proposals, a well-informed, technically alert back-and-forth Requirements Should Reﬂect the Risk between the public and private sectors on the Proﬁle of the Business basis of careful impact studies is essential to get The IIF has long advocated that regulatory to a more stable but balanced and coherent set of requirements should, in order to achieve robust requirements. outcomes and to avoid competitive distortions, reﬂect the risk proﬁles of different business lines. Basel II Remains the Correct Basis This should be reﬂected in, for example, recog- Even though public capital injections have been nition of the different risk features of different necessary in several cases, the industry has raised business activities such as banking, insurance, large amounts of capital from private sources asset management, or investment advice. As despite adverse conditions. Revisions to portfolio stated, the important issue is not the legal nature composition and asset divestitures are already of the entity but rather the risk proﬁle of the resulting in reduced risk and greater capital activities carried on. adequacy. The IIF shares the G-20 view that, with The Need for an Integrated Perspective necessary adjustments, Basel II remains by far the and Aggregate Assessment best framework for setting the regulatory capital This work needs to be conducted within an requirements of ﬁnancial institutions and that all integrated perspective. It is clear that the combi- jurisdictions, including the United States, should nation of current capital requirements under move expeditiously to effective implementation Basel II, the effects of the inclusion of downturn of the new Accord. In addition to setting capital default data and reduced ratings into banks’ requirements on a rigorous basis, Basel II will internal ratings-based (IRB) models, and the continue to increase resilience by inducing capital resulting from the implementation of the ongoing improvement in risk management. various enhancements to Pillars 1 and 2 proposed Industry participants agree that the ﬁrst step is by the Basel Committee will deliver signiﬁcantly the Basel Committee’s current revision of the greater capital levels. risk-capturing features of Basel II. This follows New capital requirements for resecuritiza- the conviction that unless risk is appropriately tions and trading book assets will dramatically captured, minimum regulatory capital ratios increase Pillar 1 regulatory capital. Indeed, the (whether 8% or above) will not be meaningful original proposals would have substantially nor serve their purpose. overshot the signiﬁcant increase of capital for the Recent changes by the Basel Committee trading book that is agreed to be necessary by aimed at improving the risk capture of Basel II industry and regulators alike. Although the ﬁnal address the most pressing deﬁciencies evidenced standards published in July 2009 appear to be an by the crisis: the capital treatment of resecuritiza- improvement, a careful impact assessment needs tions, exposures to off-balance sheet vehicles, and to be done, and the industry is still studying the trading book capital needs. Equally, strengthening 36 ■ Restoring Conﬁdence, Creating Resilience revised standards. As with all aspects of Basel II, getting a complex new system right. Given that consistent implementation of the new trading immediate problems of the crisis have largely book regime will be critical, all the more so been addressed, time should be allowed for because of the international nature of the trading meaningful impact assessments and analysis markets. Thus, it is important that the pending before ﬁnalizing new requirements. Capital Requirements Directive amendments The timing of such an evaluation is critical. in Europe be modiﬁed on the lines of the ﬁnal While there is a need to act decisively, capital Basel version and that the United States and other deﬁciencies in most large ﬁrms are being countries faithfully implement it promptly. addressed. The effects of all the changes that are Additional Pillar 2 amounts determined by being proposed will require adequate time for regulators, including the potential impact of new analysis. The analysis should be free of artiﬁcial stress tests, will likely add signiﬁcantly to the deadlines, and ﬁnalization of each change of the overall impact. Similar effects will result from prudential capital regime should be made subject additional capital buffers and measures designed to appraisal of the likely all-in effects of the to lessen procyclicality on a basis as yet to be coming changes. determined, a potential leverage ratio constraint, Although the ﬁnal standards published in and a new and perhaps more limited deﬁnition July 2009 correct in substantial part what could of Tier 1 capital. Furthermore, requirements for have been very serious unintended consequences liquidity buffers need to be considered jointly for correlation trading, and the industry is still with capital requirements, given the effects studying the revised standards, it is clear that they will have on cost structures and funding not all unintended consequences, including strategies. All this needs to be evaluated on an disruption of risk management of existing aggregate, not on a proposal-by-proposal, basis. positions and likely impacts on the market prices The implementation of Pillar 2 was discussed of certain instruments, have been addressed. further in Sub-section 2.2. The industry looks forward to continuing to Despite the evident need of integrated work with the Basel Committee on the projected assessment, there is not as yet an estimation further reﬁnements as the Basel Committee’s of the magnitude of the capital effects the impact analysis continues. pending changes will produce. Therefore, there is an urgent need for a thorough study of the Earnings Capacity overall impact of the new regime by the Basel While capital and other protective measures Committee in close consultation with the are of essential importance, earnings and the industry. This analysis should be aimed at deter- capability to generate revenue commensurate mining the actual level of total and Tier 1 capital with a reasonable return are the foundation of resulting from the various enhancements and ﬁrms’ viability. Solid, sustainable earnings and additions to the Basel II framework, combined the market conﬁdence that go with them are with the impact of liquidity and other changes. essential to developing lending capability and This is critical because of the danger of damaging longer term resilience—and thus to ﬁnancial unintended consequences for the whole market system stability. Indeed, earnings capacity has from overshooting a reasonable and necessary appropriately been examined in conjunction with increase.14 Nothing is more important than 14The Quantitative Impact Study currently being conducted by the Basel Committee covers only the trading book and market risk proposals (that is, excluding the impact of Pillar 1 requirements for securitizations in the banking book and exposures to off-balance sheet vehicles, as well as the very comprehensive changes to Pillar 2 in the areas of stress testing, ﬁrm-wide risk management, valuation, and so forth). Institute of International Finance • July 2009 ■ 37 capital in crisis-related, ofﬁcial-sector stress tests regulatory requirements that affect their invest- of individual ﬁrms’ ability to weather possible ments. A lengthy discussion of where capital is to further downturns. On a more macro basis, the come from as state investments are reduced is not solidity and diversiﬁcation of earnings across the within the scope of this report. It is, however, vital ﬁnancial services industry is an important aspect that this issue be given a higher proﬁle in interna- of its ability to contribute to recovery and then tional public- and private-sector discussions. sustained growth. Thus, balancing capital and other safeguards with the capacity to generate International Coordination and Good earnings is absolutely necessary, although often Timing Essential overlooked in public discussions of capital and Among the most fundamental needs felt by IIF prudential issues. members are for international policy coordi- nation and adequate timing of the reforms. Innovation Changes in the capital regime should be Over the past 50 years, market-driven innovation consistent internationally and not create market has made tremendous contributions to economic distortions or make unlevel the playing ﬁeld. welfare. It can also, of course, be misused. Certain Similarly, although the point is certainly recog- recent innovations have compounded complexity nized by the Basel Committee, it is important and opacity, obscuring underlying risks, which not to introduce new requirements that would became grossly disproportionate to any beneﬁts. contribute to short-term procyclicality by dimin- These problems have been recognized widely, and ishing further the already reduced credit capacity are being dealt with by several initiatives. The of the system. Rather, introduction of new IIF is committed to building upon the progress requirements should be phased in once recovery already made to achieve the levels of transparency is well established. and market discipline necessary to avoid such dangers in the future. Innovation remains Credit Capacity and Securitization essential to future progress, and will proceed in Until recently, securitization remained the main a context of stronger risk management, good source of credit outside of bank balance sheets. governance, and effective supervision based on However, the cumulative effects of the various the lessons learned of the crisis. In carrying out changes may end up seriously hobbling the regulatory reform great care must be taken not to system’s lending capacity. deﬁne requirements so narrowly as to constrict or While complex resecuritizations should be cut off future innovation. subject to signiﬁcantly increased capital charges (although the market for them seems unlikely Strategic Considerations for Capital Raising to return in any case), they should be clearly Importantly, both the industry and supervisors differentiated from the more vanilla or standard will need to consider whether the framework is types of securitization that have been essential adequate to attract equity investors with medium- to provision of credit for asset categories such as to long-term investment views as a part of the automobile ﬁnance, student loans, credit cards, overall problem of improving the incentives and the familiar types of mortgages, which have to which the industry responds. The roles that performed well for many years until the problems hedge funds, sovereign wealth funds, insurance originating with sub-prime mortgages spiraled companies, and pension funds can play are out of control. crucial but will require reconsideration of various 38 ■ Restoring Conﬁdence, Creating Resilience There remains a serious danger that the be implemented. Without belaboring what has accretion of proposals for securitization, already been an extensive debate, there remain including increased capital requirements, doubts about whether the requirements will accounting changes, rating agency changes, and achieve their stated goals. Moreover, there “skin-in-the-game” retention requirements, is concern that their downsides of making may make it difﬁcult to securitize the necessary securitization less attractive for certain ﬁrms, volume of assets to sustain adequate lending more costly in capital terms, and more complex capacity. to manage both as a business matter and for It is important not to force transactions purposes of risk management, will outbalance any on-balance sheet, either by accounting or gains. Concerns about the quality of transactions by regulatory requirements, beyond what is that have prompted these proposals—which are necessary to correct true excesses of the prior quite legitimate looking only at the period prior period. In getting the balance right, not only to July 2007—are in fact well on the way to being should the need to maintain the conditions under addressed by other means. which securitization can continue to be done As important as taking the aggregate effects be factored in, but also the fact that substantial of changes into account is close international improvements in disclosures of off-balance sheet alignment of all such requirements, which will positions via Pillar 3 have already been promul- have a signiﬁcant effect on how future transac- gated (see Sub-section 5.4). tions are done. The support of securitization by some of Substantial industry initiatives are under the government intervention programs shows way to upgrade the documentation and trans- its importance. Yet it is not clear that the overall parency of securitization, including the European effects of pending changes on this vital and Securitisation Forum’s RMBS Issuer Principles for reliable means of ﬁnance are being evaluated Transparency and Disclosure15 and the American carefully, as new requirements are being Securitization Forum’s Project RESTART.16 These developed individually. initiatives should make it possible for securitized Finalization of a new regime for securitization ﬁnance to resume its essential role without recre- needs to take into account the interaction of all ating the risks that now well-understood excesses the various proposals under consideration. Some raised. Transparency is discussed further in issues are still being debated, such as the derecog- Section 5 below. Moreover, extensive changes in nition and consolidation rules of accounting, and origination of underlying assets and in under- the IIF is making its contributions to that writing standards and practices are being made as debate, as on the corresponding prudential a result of regulatory requirements and industry regulatory and disclosure requirements regarding recommendations such as those in the Market off-balance sheet exposures. Others, including Best Practices Report. some of the recent Basel risk-weight modiﬁca- tions for resecuritizations, are relatively uncon- troversial, although the impact of treatment of securitizations in the new trading book require- ments is yet to be analyzed fully. 15 December 2008, see http://www.european “Skin-in-the-game” retention requirements securitisation.com. have been debated at length and are still going 16 July 2008, see www.americansecuritization.com/ through the political process but appear likely to restart. Institute of International Finance • July 2009 ■ 39 Furthermore, there is a need for thorough analysis Commitment VI: Levels of capital in many and hard data in order to develop a conﬁdent parts of the system were insufﬁcient. The IIF understanding of the real nature and extent of agrees that overall levels need to be increased, procyclicality in the regulatory capital framework. within the framework of the Basel II risk-based approach, as compared to pre-crisis levels. The Buffers Must Be Able to Be Drawn IIF membership stands ready to work with the in a Downturn regulatory community on objective analysis It is important that any measure be objective, of the cumulative net impact of proposed transparent, and free of unintended consequences regulatory changes. (in particular, in how it could affect the way ﬁrms Recommendation 10: The cumulative manage risks internally). If there are to be capital impact of proposed enhancements of capital buffers, or reserves, it is of fundamental impor- requirements and other regulatory and tance that they be truly available to be drawn accounting changes should be fully assessed down in economic downturns. Without this prior to ﬁnal decisions being made. the result would be wasteful overcapitalization without real beneﬁt. This requires not only a Recommendation 11: The timing of regulatory commitment but also buy-in from introduction of new requirements should be the rating agencies and the market. The Basel carefully considered to ensure that they do not Committee needs to give a high priority to this hinder recovery. aspect of the problem. Clarity Is Essential as to Aims 3.2. ADDRESSING CAPITAL Furthermore, debate is needed as to whether CYCLICALITY buffers should be speciﬁcally countercyclical or It is agreed that measures need to be taken to aimed only at mitigating artiﬁcial procyclicality reduce levels of cyclicality in regulatory capital of the regulatory capital framework. While both requirements. Firms also are considering this objectives deserve consideration, explicit counter- from an internal risk management perspective. cyclical buffers present additional challenges. Not For example, ﬁrms are adopting a longer only would such buffers be extremely complex perspective on capital planning, even at the level to use, but they also would require vesting of the deﬁnition of risk parameters. A dialogue extensive discretionary powers in regulators on the basis of the ofﬁcial sector’s parallel work and central bankers, which could subject under the G-20 mandate will be necessary as that them to unmanageable political pressures that work becomes more fully available. The related would compromise their independence and the issue of cyclicality of loan loss provisioning is achievement of their properly regulatory goals. discussed further below in this section. Various ideas have been ﬂoated to address Discretion Should Be Limited procyclicality. The industry generally is Given that cycles will vary somewhat by country, supportive of the concept of measures to reduce determination of where in the cycle a speciﬁc the procyclicality of regulatory requirements, jurisdiction is (and the related decision of including consideration of time-variable capital whether or not banks should be able to draw buffers or reserving. But the devil is in the details, from the buffer) is a central question. Alternative and there is as yet no consensus on how to approaches include discretionary mechanisms achieve what is in fact a difﬁcult technical goal. 40 ■ Restoring Conﬁdence, Creating Resilience (by individual ﬁrms, prudential regulators, or 3.3. DEFINITION OF CAPITAL systemic regulators) and formulaic (non- The deﬁnition of regulatory capital is an discretionary) mechanisms. At this point, and important variable as international standard- subject to more detailed debate, the industry’s setters consider the speciﬁc contours of a revised view is that discretionary elements should be regulatory capital framework. IIF members agree reduced to a minimum in order to make the that a review of the quality of regulatory capital process objective, predictable, and transparent. and its deﬁnition as interpreted in different jurisdictions should be undertaken. The Approach Should Be an Integrated One Importantly, consideration also is needed as Market Developments Must Not to the relationship between potential future Exclude Debate international capital buffers or reserves and the To some extent, market demand has already capital buffer mandated by regulators in various started to drive the process of revising what jurisdictions as a result of crisis-driven “stress should be the components of ﬁrms’ capital. tests.” In particular, it is necessary to determine However, it is imperative that a thorough analysis the speciﬁc objective sought by each measure in and debate take place before making policy order to avoid potential overlapping and inefﬁ- decisions on the regulatory deﬁnition of capital, cient requirements. as current market pressures may not be the right guide for a long-term deﬁnition of capital. Coordination Is Important More broadly, international coordination on any International Consistency Is Essential decision to impose capital buffers or reserves International consistency is essential. Any review on top of other capital requirements is of vital must be highly coordinated in order to achieve importance. While the economic cycle can vary convergence of interpretation and implemen- across jurisdictions, it is important that objective tation. A “common language,” avoiding major criteria be established so that competitive distor- interpretative divergences in the future, would tions do not arise. help avoid competitive disparities and inefﬁ- ciencies in how regulators and markets deal with Commitment VII: The IIF supports measures ﬁnancial crises and bank insolvencies. to counter cyclicality by building resources in The Basel Committee is undertaking an good times that can be drawn down in bad analysis of the deﬁnition of capital. The industry times. is committed to participating in this discussion Recommendation 12: Buffers, whether constructively, guided by the overall objective of created by capital or reserves, should be able ensuring high-quality Tier 1 capital, including to be drawn on when needed without adverse common equity, retained earnings, and robust consequence. forms of preferred stock or instruments with similar loss absorption capabilities, subject to Recommendation 13: There should be internationally agreed deductions. dialogue between the ofﬁcial sector and the industry to develop effective approaches to the Accounting and Tax Effects Should very difﬁcult task of evaluating the cycle and Be Considered deciding when to apply buffer mechanisms, on the upside or the downside. Some disparities across jurisdictions derive from inconsistencies between International Financial Institute of International Finance • July 2009 ■ 41 Reporting Standards (IFRS) and Financial way of banks’ using such instruments when Accounting Standards Board (FASB) accounting market conditions permit. standards. Hence, accounting harmonization Importantly, it seems premature to adopt is part of the solution on issues related to the any ﬁnal decision on the distribution of capital elements of capital. Similarly, tax inconsistencies between Tiers 1 and 2. The original concept of play an important role and must be resolved if Pillar 1 is that it is a measure of risks in the bank a truly harmonized, stable framework is to be and careful study should be given before any achieved. Inconsistent treatment of different adjustment of the original ratios of Tier 1 and 2, instruments for tax purposes within national in terms of impact on the overall economy as well regimes and further inconsistencies across as on the prudential solvency of ﬁrms. national regimes also have a major effect on ﬁrms’ incentives as they approach their capital Tier 3 Also Should Be Considered strategies, their choices of instruments, and their Debate also is required on the future of Tier 3 relationships with the markets. capital, aimed at supporting short-term trading While the tax issue is complex, and problems exposures. As with Tier 2 capital, there should not of revenue neutrality of any change must be be a rush to judgment, but rather the future role recognized, it puts to the test governments’ of Tier 3 capital should be reevaluated once the willingness to develop a truly international whole picture on the regulatory capital treatment regime on capital. The tax dimension is funda- of the trading book is clear and ﬁrms’ adjusted mental to any discussion of ﬁrms’ capital struc- business models have settled down in the new tures, and its discussion should not be avoided. market that will emerge. Tier 2 Remains Important Impact Assessment Is Needed The current quasi-exclusive focus on Tier 1 As with other changes that have an effect on the capital is a further source of concern. While focus cost of capital and the cost of sustaining credit on Tier 1 is warranted, complete disregard of businesses, any changes to the international Tier 2 capital is not. As the system emerges deﬁnition of capital should be undertaken only from the crisis, it will be important to renew once there is a conﬁdent assessment of the recognition of instruments such as subordinated cumulative impact of all other changes under debt, which are effective as bank capital elements, consideration. particularly on a gone concern basis where protection of depositors becomes the more Commitment VIII: The IIF agrees that the relevant. This will be all the more important if quality of capital required needs to be reviewed. a more robust international resolution regime The IIF membership is ready to work closely emerges, which will make having a full range of with the ofﬁcial sector to achieve an outcome instruments available important. that reﬂects the lessons learned from the recent Moreover, it will be important to give careful period. consideration to the role of Tier 2 capital that is convertible into Tier 1. Firms with buffers of Recommendation 14: Consistent international convertible Tier 2 instruments as part of their requirements for the deﬁnition and quality of contingency plans were well served by them. capital, in particular Tier 1 capital, should be There is, of course, a question of the market’s developed. They should be applied consistently assessment of such instruments from time on a global basis. The beneﬁts of Tier 2 capital, to time; however, a sound regulatory capital including convertible Tier 2, should not be framework would not put impediments in the underestimated. 42 ■ Restoring Conﬁdence, Creating Resilience 3.4. CONTROLLING LEVERAGE Take into account differences between accounting standards17 (in particular, There is agreement that excessive leverage regarding on- and off-balance sheet items); had developed in the system, and this must be Take into account netting, hedges, controlled in the future. Signiﬁcant progress has off-balance sheet items, and differences in been made by the industry in reducing leverage as business models as differences in funding evidenced by various recent analyses. While this structures; trend continues, there also is appropriate concern Allow ﬂexibility so that its application does about the speed of deleveraging and its effects on not result in discriminatory treatment of the real economy. certain business models or certain jurisdic- tions; and Best Means of Control? Be internationally agreed and consistently Fundamentally, it is essential to have a debate on applied across jurisdictions. The macro- how to design leverage measures that will achieve effects of any supplemental measures to the goal of having a backstop to capital require- control leverage must be examined carefully, ments without putting a brake on well-managed both on a domestic and on an international risk-taking and without creating disincentives level. to business in low-risk assets. In so doing, it should be kept in mind that the more robust More fundamentally, supervisory tools capital regime will also have a substantial effect to contain leverage may be useful, but only if on leverage in the regulated ﬁnancial sector, correctly applied. Experience during the crisis which underscores that any additional measures of banks operating under jurisdictions with a against excessive leverage should be designed leverage ratio demonstrates that its beneﬁts are as true backstops to correct anomalies or not always evident, even if combined with other outlier behaviors, not to supplant sound capital regulatory tools. Consideration of leverage should requirements. clearly be part of each ﬁrm’s dialogue with its Moreover, if the goal is to prevent ﬁrms from supervisor. Rather than operating as a hard, gearing up to excessive leverage, supplemental Pillar 1 type of mandatory requirement, a supple- prudential measures are appropriate. However, mental measure looking at leverage should be it would not be appropriate to conﬂate leverage used as one indicator among many, under a control measures with the separate issue of Pillar 2 approach. whether in individual cases there should be limits If well designed, this Pillar 2 approach can on growth, scale, or diversiﬁcation of the business result in appropriately targeted supervisory inter- conducted by a given ﬁrm (see Section 4). vention, including increased monitoring, targeted remedial requirements, or additional capital Design Criteria requirements. Under Pillar 2, speciﬁc measures would be adopted only after supervisory dialogue As part of the debate on establishing at the has taken place, taking into account all the facts international level supplemental tools to control and circumstances, including such issues as leverage, it is important to underscore some the components of the assets included in the basic design criteria. Any measure should do the following: 17The industry is glad to see that the ofﬁcial sector (including in particular the Basel Committee on Banking Supervision and the European Commission) has recognized this problem but reiterates that it is fundamental. Institute of International Finance • July 2009 ■ 43 calculation (for example, government paper and High-Level Dialogue less-risky, standard mortgages), as well as the In the Market Best Practices Report and appropriate way to cover off-balance sheet assets subsequent statements, the IIF has called for a without resulting in exaggerated and dispro- comprehensive, unbiased, high-level dialogue on portionate effects. Rather than a mechanical current accounting standards in light of the crisis, tool, supplemental measures of leverage have involving all relevant parties. Although consul- great potential as determinants of enhanced tative processes have been initiated, the need for supervisory dialogue. By contrast, any simplistic, a comprehensive and integrated high-level review gross measure, applied across the board, is likely of all aspects of accounting issues in light of to reﬂect poorly ﬁrms’ actual short-term liquidity experience in the crisis remains high. situations, might induce ﬁrms to take on a riskier mix of assets than would otherwise be the case, Recommendation 16: There should be a and can distort business incentives and encourage comprehensive, high-level dialogue on current arbitrage. accounting standards in light of the crisis It goes without saying that the foregoing and the changing regulatory environment. discussion is focused on the widely discussed This should involve all relevant parties while issue of supplemental leverage measures for respecting the independence of the standard- banks. As the leverage issues facing insurance setting process. businesses are quite different, it should not be taken to apply to them. Commitment IX: The IIF agrees leverage Role of Accounting Standards was too high and needs to be appropriately in Promoting Conﬁdence controlled in the future. There should be a thoughtful review of the role Recommendation 15: A simple leverage ratio of accounting standards in international capital runs the risk of undermining its own objectives. markets. Transparency, reliability, and represen- Any measure to contain leverage should take tational faithfulness are objectives that should account of differences in business models be the key drivers of any reform in the context and funding structures, major differences in of reviewing the existing accounting regime. By risk proﬁles, distinct market practices and the same token, such a review should, wherever characteristics, and differences in accounting possible, include consideration of efforts to standards. Leverage should be addressed as a contain ﬁnancial instability. supervisory tool for use as part of the Pillar 2 The G-20 mandate “to reduce the complexity dialogue between a ﬁrm and its supervisor. of accounting standards for ﬁnancial instru- ments and enhance presentation standards to allow the users of ﬁnancial statements to better assess the uncertainty surrounding the valuation 3.5. ACCOUNTING of ﬁnancial instruments” is a step in the right This section highlights considerations for the direction. The IIF supports the accounting ofﬁcial sector that remain compelling as discus- standard-setters’ efforts to date in this regard. sions of accounting and regulatory developments It is important to conclude the current reform enter a critical phase. program expeditiously. 44 ■ Restoring Conﬁdence, Creating Resilience Convergence Standard-Setting Process The G-20 and more recent ofﬁcial statements, The IIF has continuously endorsed the indepen- such as the U.S. Treasury’s proposals on dence of accounting standard-setters. It is, regulatory reform, have consistently stressed however, part of the responsibility of indepen- the importance of international accounting dence to take account of economic and ﬁnancial convergence. It cannot be reiterated enough that developments and respond in a manner coordi- expedited convergence of accounting standards nated between boards to achieve consistency is a prerequisite to strengthening the compara- across the main international standards. bility of ﬁnancial statements for investors and Consistent with the recommendations of the regulators as well as to preventing “accounting G-20, it is in the best interests of independent arbitrage.” standard-setters and all market participants that Nevertheless, there remains ample risk of the standard-setting process involve input from fragmentation and national solutions, which may all stakeholders, including preparers and users result from inefﬁcient communication between of ﬁnancial statements, as well as prudential and standard-setters and ofﬁcial-sector decision- securities regulators (including those of emerging making bodies, given perceived tardy responses markets). This is not only a procedural matter but by the standard-setters to emerging crisis-related also a substantive one that will improve trans- issues. parency and conﬁdence in the standard-setting Rapid progress on reform and convergence process and thus lead to a broader consensus on is essential to preserving the credibility and accounting issues. independence of the standard-setters. Their The IIF is supportive of the International efforts to this end will need the active support Accounting Standards Committee (IASC) of all concerned, including especially securities Foundation Monitoring Board as a means to regulators and other authorities with oversight embrace regulatory participation in the standard- responsibilities. The standard-setters and other setting process; however, prudential supervisors concerned authorities should reafﬁrm prior should participate fully in this scheme. commitments in a clear plan for expeditious There is a clear need for expedited due process adoption of converged standards, eliminating to develop interpretive guidance or revisions existing directional and timing uncertainties. of standards on occurrence of extraordinary There have been issues on which extraordi- events or on rapidly changed market conditions narily rapid action has been required, as discussed or business practices. An established, expedited further below. Even so, however urgent responses process would contribute to avoiding divergence to current issues or to parts of the G-20 agenda between the major standards, facilitate greater may be, these responses should remain well- consistency in the application of accounting coordinated and lead toward convergence. standards, and reduce uncertainty and the risk of a non-level playing ﬁeld. A consistent expedited Recommendation 17: Achieving overall amendment process for ofﬁcial guidance, convergence in international accounting standard setting, and disclosure also is essential standards requires active support from to avoid ad hoc amendments to standards that, in all concerned, including the industry and turn, may lead to voluminous and burdensome securities and prudential regulators. There requirements that ultimately increase the should be a renewed commitment by all complexity in ﬁnancial reporting. Clearly it is stakeholders to a clear plan for timely adoption vital for expedited procedures to be designed to of a single, high-quality set of accounting further the goal of convergence for the beneﬁt of standards. users of ﬁnancial statements. Institute of International Finance • July 2009 ■ 45 The recent changes made by the FASB illustrate Recommendation 18: Exceptional processes the problem that analysis of credit deterio- should be in place to provide guidance on as ration may give value signals that are distinctly expedited a basis as possible while allowing dissimilar to other risk factors (for example, for rapid consultation with stakeholders in the liquidity) that affect market valuations. Now it event of extraordinary occurrences. is imperative for the standard-setters to quickly turn to the plan to develop common models that reduce the existing multiplicity and complexity Valuation and Impairment of different impairment schemes. New, simpler approaches should be established on a basis of use Valuation- and impairment-related issues of all available, relevant information, as the G-20 caused great difﬁculties in the ﬁnancial crisis. has mandated. Accounting guidance recently issued or currently being debated on fair-value measurement in Recommendation 19: While progress has less-active markets is consistent with the goals of been made to date on valuation in less-active achieving clarity in the standards and promoting markets, more needs to be done. Standard- convergence. There has been wider recognition setters should develop a common framework of the appropriate role of management judgment that reduces the complexity and multiplicity in valuation discussions and the need to avoid of existing impairment models on the basis of mechanistic mark-to-market responses. all available relevant information. This should However, more can, and should, be done. be done on a fully convergent basis, taking into On valuation, the consistency of application of account the lessons learned from the crisis. accounting guidance for valuation in difﬁcult markets across ﬁrms and over time needs to be solidiﬁed. More work in particular needs to be done to integrate valuation adjustments into the Fair-Value Accounting process on an appropriate and transparent basis. The IIF continues to be of the view that, while The process should codify, on a fully convergent fair-value accounting has clear beneﬁts for both basis, guidance on use of valuation adjustments users and preparers of ﬁnancial statements for liquidity and other risk factors in various for certain ﬁnancial instruments, fair-value market conditions. measurement may not always provide the best Transparency of the valuation process is reﬂection of cash ﬂows due to a reporting entity essential and, again, changes in guidance to date operating on a longer term business model. have been helpful but need to be integrated to Work is in progress to improve the present mix ensure clear understanding by all issuers, large of fair-value and accrual accounting for ﬁnancial and small. While understanding of difﬁcult institutions. It is important to stress that the market conditions has improved and the role of next few months’ work by the two accounting judgment is better understood, distortions caused boards, in consultation with the industry and by interpretation issues will be avoided only other interested parties, will be crucial. Much when ﬁnal and converged guidance and standards can be done. The IIF proposed suggestions for are available and fully accepted by auditors and the classiﬁcation of ﬁnancial instruments to regulatory authorities. the International Accounting Standards Board Open discussion of the informational quality (IASB) in connection with its joint project with provided by existing impairment models has the FASB on simplifying accounting for ﬁnancial begun but needs to be pursued as a top priority. instruments. 46 ■ Restoring Conﬁdence, Creating Resilience The IIF proposals are based on the premise Furthermore, existing rigidities in hedge that consistency between the accounting accounting18 lead to disincentives for preparers framework and the reporting entity’s business to elect hedge accounting treatment for ﬁnancial model is paramount for faithful representation instruments carried at amortized cost. This of the economic substance of transactions. contributes to earnings volatility, as the hedging Factoring in the ﬁrm’s business model provides instrument will be carried at fair value while a robust, objective standard and relates directly the hedged item is not. The fair-value option to fundamental business realities, facilitating has helped reduce this volatility, as it provides market discipline. Improvements to the allocation users with the ability to achieve economic hedge of assets between amortized-cost and fair-value accounting without the associated risks and has categories (as the IIF has proposed) will provide a legitimate role in a simpliﬁed scheme, provided better information to users by aligning reported that issues related to gain and losses on an entity’s values with the business model and use of assets. own credit are resolved. This approach also would allow the standard- setters to address a number of the criticisms of Recommendation 20: Fair-value accounting fair-value accounting in the current environment. has clear beneﬁts in appropriate contexts. One particularly important aspect is the However, questions have been raised impact of any near-term changes in the classi- concerning its effects on cyclicality, and it may ﬁcation model on the ﬁnancial statements of not always provide the best reﬂection of cash insurance entities. Insurance business models ﬂows due to a reporting entity. Work currently include holding ﬁnancial assets for the medium in progress to review fair-value and accrual to long term to back insurance liabilities and for accounting for ﬁnancial institutions should risk and asset liability management. Any change continue with urgency. It should also address, requiring measuring such assets at fair value as part of the comprehensive simpliﬁcation through proﬁt and loss would lead to artiﬁcial of ﬁnancial instrument reporting, existing earnings volatility and accounting mismatches, rigidities in hedge accounting. given that insurance liabilities are not measured on the same basis. It is vital for insurance entities to be able to maintain the current “fair value An Entity’s Own Credit through other comprehensive income” category of investments, at the very least until new Reﬂection of changes in an entity’s own credit standards on insurance contracts are effective. standing in its earnings is another source of Dealing effectively with classiﬁcation between concern to many. While opinions on the utility of fair-value and accrual accounting also should recognizing changes in an entity’s own credit to provide the basis for avoiding further divergence provide meaningful information to investors are between ﬁnancial accounting and regulatory divided, it is clear there is much discomfort with capital requirements. Whereas it has been a goal this aspect of fair-value accounting. The contro- of all parties for years to maximize convergence versy about recognition of own-credit changes between the two regimes, an unfortunate effect of extends both to the substance of the current rules crisis-driven accounting controversies has been to and also to the range of practices in their cause some to conclude this may not be feasible. Convergence rather than divergence between 18 the two should remain a high-priority goal of all Hedge accounting requirements under U.S. GAAP and IFRS require extensive documentation concerned. A good result would contribute to and substantial resources for assessment and transparency and ultimately to stability. measurement of hedge effectiveness. Institute of International Finance • July 2009 ■ 47 implementation. Importantly, it does not reﬂect However, in recent years, securities regulators management’s view of a ﬁrm’s liabilities. have criticized “excess” provisions, with the result Extreme movements in credit spreads over that preparers and auditors often have taken a the past two years illustrate the widely made much more restrictive approach to establishing argument that recognizing changes of own credit provisions than reasonable judgment about loan in earnings often are not meaningful. This is losses would suggest. Consequently, it appears because it is commonly not possible for an entity that a narrow interpretation of the incurred-loss to realize the beneﬁt of own-credit deterioration model has become widespread in practice. This by transacting in its own liabilities to any great has had the unintended consequence of delaying extent. The existence of credit deterioration the recognition of portfolio loan losses, exacer- may indicate that an entity is not in sufﬁcient bating the effect of procyclicality. economic health to expend cash to realize the In line with the recommendations of the earnings beneﬁt of retiring debt for less than its FSB, the IIF has called for interpretive guidance, notional amount. authoritatively backed by the ofﬁcial sector, The IIF supports the current reconsideration to enable practitioners to apply reasonable of own-credit issues, which should include a close judgment in assessing loan losses by taking into examination of such factual issues, how they consideration a broader range of available credit complicate the use of the fair-value option, their information. This will result in more consistent impact on insurance accounting, and questions and less procyclical loan loss practices that are arising from the range of practice in implemen- consistent with existing accounting literature. tation of the current rules. The issue is whether management will feel comfortable exercising judgment accordingly, and Recommendation 21: Reporting changes in this depends largely on whether the auditors and an entity’s own credit in earnings is a source securities regulators follow the standard-setters’ of controversy. The debate should consider guidance and accept provisions based to a greater whether elimination of recognition of changes extent on professional judgment. in the reporting entity’s own credit quality in Several ofﬁcial-sector reports, including those reported earnings would provide simpler, more of Working Group 1 of the G-20 and the FSB,19 direct, and more decision-useful information to recommended a medium-term broader review the market. of loan loss provisions by analyzing alternative models that incorporate wider ranges of credit information. With the objective of advancing the discussion, the IIF submitted to the Financial Procyclicality and Loan Loss Provisions Crisis Advisory Group on behalf of members Several ofﬁcial-sector commentaries have two alternative proposals that incorporate credit criticized the current incurred-loss provisioning information that is not currently utilized under model for exacerbating procyclicality on grounds the incurred-loss model. One is a revised version that, because of non-recognition of inherent loan of the Spanish dynamic provisioning method losses in portfolios, it may contribute to market intended to recognize impairment earlier in the pressure for high levels of dividends and share economic cycle; the other is a proposal for a buybacks and to distortion of compensation 19FSB, Report of the Financial Stability Forum on calculations. Current accounting standards, in principle, permit considerable management Addressing Procyclicality in the Financial System, judgment in establishing provisions. April 2, 2009. 48 ■ Restoring Conﬁdence, Creating Resilience change of standards to put provisioning on an expected-loss basis similar to that in the Basel Recommendation 22: Consistent guidance capital accord. These proposals are now being should be issued by the major standard-setters debated as part of the reconsideration of the to allow the use of reasonable interpretation existing provisioning model. in assessing loan losses under the incurred- On the related issue of the treatment of loss model. Such guidance should be given accounting provisions for regulatory capital the unambiguous backing of securities purposes, it is clear that the regulatory capital regulators in order to help avoid the overly framework should not create disincentives for narrow applications that have contributed adequate provisioning; however, contrary to a fear to procyclicality. The current review to some have expressed, it does not appear to the consider the reﬂection of a wider range of IIF that the present rules limiting the inclusion credit information in standards for loan loss of provisions in Tier 2 capital have a substantial provisioning must be given priority. effect on provisioning decisions. On the contrary, given that provisions will be more readily usable The discussion above highlights challenges if treated as reserves (that is, not included in arising from the ﬁnancial crisis that are still regulatory capital), the present limited use of being faced by accounting standard-setters. provisions in capital should not be expanded. While progress has been made to date, and the It is, of course, essential that provisions—as IIF applauds these efforts, many issues remain with any capital buffers or related reserves— outstanding that require discussion and delib- actually be usable against incurred losses as ﬁnally eration by all constituents. It is important to taken; any solution should be designed to allow maintain an open and transparent dialogue that provisions to be usable without accounting, includes all interested parties, takes into account regulatory, or market impediments. Therefore, issues raised by the crisis, and balances the need consideration should be given to excluding provi- for urgent action with assessment of feasible sions from capital altogether as a way to make implementation. provisions usable and also limit capital volatility. Whichever regulatory treatment of provisions 3.6. LIQUIDITY is decided on, it is fundamental that adequate transparency be provided, as users of ﬁnancial The IIF issued an extensive discussion of liquidity accounts should be able to determine clearly how risk management in March 2007, updated in the ﬁrms create and use provisions. July 2008 Market Best Practices Report, including However, regulatory policies on provisioning recommendations for assessment of liquidity risk, cannot deal with the issue of incentives in liquidity buffers, and other risk mitigants. The isolation. Tax rules play a fundamental role Basel Committee published in September 2008 its in provisioning decisions and ought to be Principles for Sound Liquidity Risk Management considered as part of any comprehensive review. and Supervision. There is general consistency between the IIF recommendations and the Basel Principles, which the FSB found to meet the G-20’s initial concerns on liquidity. The Basel Principles, if properly enforced, deﬁne a rigorous approach to liquidity risk management and supervision. For reasons noted below, any moves beyond those principles need to Institute of International Finance • July 2009 ■ 49 be carefully debated to avoid material unintended exposure, balance-sheet leverage, and capital consequences. needs and also reduce unused wholesale funding Firms have already enhanced their liquidity capacity, ultimately lessening the efﬁciency of the risk management and, subject to difﬁcult market ﬁnancial system overall. conditions, have been building liquidity buffers Following the Basel and IIF Principles, ﬁrms and working toward compliance with the Basel have substantially reinforced their liquidity risk principles. In addition, they continue to manage management. They increasingly set limits and their liquidity to ensure that local liquidity needs assess needs in each market. One aim of internal can be met, using conservative assumptions and liquidity risk management—and of its super- setting local limits where appropriate. vision by regulators—is to make sure that conser- As banks have been working to meet the Basel vative assumptions are used and limits set. Firms Committee’s principles, the insurance industry may use more centralized or more decentralized will need time to work with the IAIS to make sure approaches, but the assessment of local market the quite different liquidity issues that arise from needs is always taken into account. The special insurance activities are appropriately addressed. needs of smaller currencies are, of course, part of the analysis. And, of course, regulatory attention Commitment X: IIF members have already to the quality of liquidity risk management has enhanced their liquidity risk management and, been substantially increased. subject to difﬁcult market conditions, have The UK Financial Services Authority (FSA) been building liquidity buffers and working has announced a proposal to require ﬁrms to toward compliance with the IIF and Basel “ring-fence” assets of UK subsidiaries of foreign liquidity principles. In addition, they continue ﬁrms in order to prevent another case of assets to manage their liquidity to ensure that local being swept from a local operation prior to liquidity needs can be met. IIF Members will a ﬁrm’s failure, as in the Lehman Brothers continue the ongoing enhancement of their collapse.20 Other countries have announced approach to liquidity management. somewhat comparable measures. From any country’s point of view, maximum requirements might appear prudent, but this can only put the brakes on global recovery, Self-Sufﬁciency Approaches and Trapped global ﬁnance capacity, and ability to respond to Pools of Liquidity global liquidity problems. The FSB Principles for Both ﬁrms and the global ﬁnancial system will Cross-Border Cooperation on Crisis Management be more resilient if ﬁrms are able to manage their acknowledges that local ring-fencing complicates liquidity needs on a group-wide basis. Central ﬁrms’ funding plans. treasury oversight of the ﬁrm’s liquidity opera- Any local requirements should take into tions is essential to good risk management and account not only domestic needs and risks, but proper internal pricing of liquidity. Major ﬁrms’ also the cumulative effects of such requirements internal liquidity ﬂows can contribute signiﬁ- on the global system. Also, whereas the risks of cantly to sustaining liquidity in a global system. market funding are now widely recognized, it For these reasons, IIF members have argued is paradoxical that ring-fencing may make local strongly against local requirements that create ofﬁces of global groups—which often do not have “trapped pools of liquidity.” Unnecessary local extensive retail deposit bases—more dependent requirements that “trap” liquidity will unduly 20 increase each ﬁrm’s group-wide third-party credit UK FSA Consultation Paper 8/22, Strengthening Liquidity Standards, December 2008. 50 ■ Restoring Conﬁdence, Creating Resilience on wholesale market funding. Above all, such with a more jurisdiction-focused approach requirements should be consistent with the Basel to allocation. Such an approach could give principles and not implemented without careful signiﬁcant reassurance to national supervisors by international coordination through the Basel avoiding liquidity voids. Committee and the FSB. It remains unclear at this stage whether such an approach would be feasible given An Industry Contribution to Be Explored legal constraints, differing risk management techniques, and so forth. However, industry One great obstacle to enhanced global regulatory participants wish to explore with the ofﬁcial integration, and a signiﬁcant cause of resurgent sector the extent to which such an approach jurisdiction-speciﬁc self-sufﬁciency, is a fear that might be feasible and productive. This could be a in the event of the failure of a group, the stake- useful issue for the FSB to take up in its capacity holders of the jurisdiction in question will ﬁnd as coordinator of the activities of colleges of themselves prejudiced in favor of stakeholders in supervisors. other jurisdictions. It has been suggested that one way for Commitment XI: Good liquidity risk the industry to help would be for the parent management should take into account local company of a group to provide guarantees for market needs. In addition, the IIF is committed its subsidiaries. This, however, does not solve the to exploring ways in which ﬁrms could problem, as in the end this produces a burden organize their cross-border business to reduce of broadly similar dimension for the group as a the concerns of authorities that individual whole in terms of combined liquidity and capital jurisdictions would suffer disproportionate loss requirements. In other words, it would replicate, in the event of an insolvency. This should take in modiﬁed form, the inefﬁciency that is sought place in the context of the ongoing dialogue to be avoided. between large ﬁrms and the authorities An alternative suggestion would be for cross- concerning the information necessary to plan border groups to seek to carry on their liquidity for the orderly exit of the ﬁrm should that management in a manner such that in the event prove necessary as discussed in Section 4. Such of a failure of the group or part of the group, the an approach would take into account the extent to which losses fall disproportionately on legal structure of the group and differences in one jurisdiction as compared with another would insolvency laws across jurisdictions. The IIF be minimized. The aim would be to avoid the stands ready to work with the ofﬁcial sector undue prejudice of one jurisdiction over another. to reduce the real dilemmas that the tensions The operation of such an approach might be tied between global and local goals for good to the proposal in Section 4 for large or highly liquidity management present. interconnected ﬁrms to examine with their authorities the risks that their role in markets and Recommendation 23: Although the serious products create to help the authorities assess what issues raised by failures of major market would happen in the event of their failure. participants need to be addressed, the Such an approach would take into account the signiﬁcant drag on system efﬁciency created by legal structure of the group and be subject to the “trapped pools of liquidity” also is important constraints of law, including differences of insol- and needs to be taken into account. Self- vency laws across jurisdictions. The effect of this sufﬁciency or stand-alone approaches to might be to achieve a combination of “top-down” liquidity regulation should be resisted by calculations of the liquidity needs of the group regulators. Institute of International Finance • July 2009 ■ 51 Liquidity Buffers Eligible Assets for Liquidity Buffers Liquidity buffers raise different cyclicality The UK proposals conﬁne assets eligible for issues from capital buffers. Whereas loan loss liquidity buffers narrowly to a limited list of state expectations naturally move with the credit obligations.21 Such requirements are not without cycle, liquidity risk is not smoothly cyclical but logic from one viewpoint, but they go too far and instead tends to move suddenly in response to may have several unintended consequences if market incidents. Thus, an extremely conservative adopted broadly. approach to liquidity buffers would require A restrictive deﬁnition of eligible assets, and very high liquidity buffers at almost all times the need for extensive portfolios of such assets as insurance against “perfect-storm” conditions for liquidity buffer purposes, will necessarily that would be much less predictable than credit affect the markets for eligible and ineligible cycles. This would be counterproductive from an assets. Eligible assets, if deﬁned too narrowly, economic viewpoint. may actually become signiﬁcantly less liquid, as As part of the further development of interna- they will need to be held in large amounts for tional practice on liquidity buffers, it is important liquidity buffer purposes. The negative effects on to agree on when or under which scenarios a non-eligible traded debt markets will delay their bank can actually use its liquidity buffers. The recovery, increasing reliance for ﬁnance on bank circumstances under which buffers will be able loans, thereby creating pressure on bank liquidity. to be drawn down must be clearly deﬁned and The mark-to-market effects of many ﬁrms’ accepted by all parties in order to have the desired disposition of a narrow category of eligible effect. assets also need to be taken into account. If, Prior IIF work has demonstrated at length in a systemic event, many ﬁrms sought to use that regulatory liquidity requirements cannot be the same assets, prices would be depressed, applied across the board and that one-size-ﬁts-all and markets could seize up, triggering another requirements will end up with distorted incen- downward spiral. tives and missed risks. Rather than setting a priori requirements, it would be better both for overall liquidity and Commitment XII: It is necessary to hold for the market as a whole if requirements allow liquidity buffers against liquidity risk. This is for a range of solutions, based on objective an important part of a robust overall approach liquidity analysis. Any analysis that excludes to liquidity risk management. a class of asset that is eligible at major central banks in ongoing operations should be carefully Recommendation 24: In determining a ﬁrm’s liquidity buffer, mechanistic approaches that 21From Strengthening Liquidity Standards: “The assets do not take into account the overall business in the buffer should be the most liquid by virtue model, funding proﬁle, and market context of of the signiﬁcant depth and resilience in stressed the ﬁrm are likely to be counterproductive and conditions of the established markets in which they should not be adopted. are traded. We consider these to be: Highly liquid, high-quality government debt instruments as follows: gilts, plus bonds rated at least Aa3 issued by the countries of the European Economic Area, Canada, Japan, Switzerland, and the United States; and Reserves held with the Bank of England’s reserve scheme and with the central banks of the United States, the EEA, Switzerland, Canada, and Japan.” 52 ■ Restoring Conﬁdence, Creating Resilience considered; exclusion of a central bank–eligible prudent or useful to set liquidity limits across instrument may have signiﬁcant and unnecessary many ﬁrms. Rather, rigorous deﬁnition of the consequences, depending on the facts and metrics and limits to be applied to a given ﬁrm’s circumstances. IIF recommendations always have business needs to be subjected to extensive stress made clear that the ﬁrst line of defense is not the testing, as also discussed in prior work. Assump- central bank; however, central bank–eligible assets tions, hurdle amounts, and other parameters need will generally have the ability to generate cash by to vary with the circumstances of a given ﬁrm in sale, repo, or other use as collateral in the market. its markets, taking into account legal entity and In determining the marketable assets available other considerations, and they need frequent for liquidity buffers, the speciﬁc range of liquidity reevaluation. needs to be met must be considered. Assets that It would, however, be desirable to develop can be monetized (that is, disposed of or used international agreement on standard liquidity as collateral) on a one-week basis may provide reporting requirements and formats (as, indeed, substantial coverage, whereas limitation of buffers the UK FSA has suggested). Having to produce to, say, assets that can normally be monetized inconsistent external reporting requirements overnight may add unnecessary rigidity. Going will create substantial burdens and chances for further, a ﬁrm may have spare stable funding error by ﬁrms, distracting management attention from relationship deposits; dependable, unused from the more acute and actionable internal capacity from wholesale sources; or reliable liquidity metrics, and undermine the cause of commitments. Thus, the important issue is to international regulatory cooperation. This is not have a high degree of conﬁdence, demonstrable just a matter of the formats, scope, and granu- to the supervisor, that these sorts of liquidity will larity of reporting but instead goes to the need to be accessible when needed. It also will often be harmonize fundamentals, such as deﬁnitions of appropriate for smaller institutions to hold paper ratios and basic terms. issued by larger institutions as part of a diversiﬁed Another issue concerns the extent of public portfolio of assets. disclosure. While it is appropriate to disclose information on liquidity risk management Recommendation 25: Overly narrow frameworks, disclosure of liquidity positions deﬁnitions of eligible liquid assets for liquidity as such can be destructive of liquidity, and any buffers should be avoided as a matter of new requirement should be studied carefully to proportionality and to avoid unintended provide market-useful information while at the consequences. The deﬁnition of eligible assets same time not undermining systemic stability. should be both coordinated internationally and developed in tandem with revised (and Recommendation 26: There should be coordinated) central bank lists of eligible comprehensive international coordination. collateral for ongoing monetary operations and This includes liquidity reporting requirements, (non-emergency) liquidity purposes. as proliferation of detailed but inconsistent requirements across jurisdictions will impose undue burdens and costs, contribute to systemic vulnerability, raise compliance risk, and Tools, Metrics, and Benchmarks distract from the clarity of internal reporting to As the IIF work on liquidity argues, and as recog- management. nized in the Basel Principles and the FSA consul- tative paper, it is unlikely that one metric will be Institute of International Finance • July 2009 ■ 53 Core Funding wholesale deposits, may, in fact, be highly stable “relationship deposits” for a number of business A ﬁrm’s funding is central to the equation. On the reasons, whereas some forms of retail deposits one hand, stability and diversiﬁcation of funding (for example, brokered and “teaser-rate” deposits) may lessen the chance of recourse to buffers; on may be less stable. In fact, overly rigid require- the other hand, excessive reliance on wholesale ments to build retail deposits would lead to funding without adequate planning can be fatal, competition for them, which would actually make as with Northern Rock. Considerations for ﬁrms’ them less sticky and less stable. Thus, as in many funding plans are discussed extensively in the other areas, a funding ratio may be a useful point prior IIF reports. of reference, but it should not become a rigid The UK’s Turner Review calls for consid- quota. eration of a core-funding ratio to “ensure sustainable funding of balance sheet growth” Commitment XIII: The IIF agrees that a and it is understood that this topic features in signiﬁcant component of funding should be current regulatory discussions. In these discus- comprised of stable elements, as part of well- sions, there is a tendency to stress the importance understood overall funding plans. of deposit funding, and this is appropriate. However, it must be remembered that a hard- Recommendation 27: A strict, mandatory target core-funding approach would likely reduce core-funding ratio should not be adopted. Such overall lending capacity, as there are limits to the an approach is unlikely to reﬂect different extent of reliance on “retail” deposit funding. degrees of stability and would be prone to The assumption that retail deposits (however material unintended consequences (such as deﬁned) are the most “sticky” may obscure the an increased volatility that would result from fact that certain classes of small and medium enhanced competition for deposits). enterprises (SME) and corporate and institutional 54 ■ Restoring Conﬁdence, Creating Resilience SECTION 4 Financial Stability Through Macroprudential Oversight 4.1. SYSTEMIC RISK AND THE NEED Challenges Ahead FOR CHANGE Despite progress, it is clear that many signiﬁcant Signiﬁcant consensus has been reached that the challenges remain to be overcome, including the ﬁnancial system as a whole—on both the market establishment of an effective response mechanism and regulatory sides—was poorly equipped to at the international level to ensure that macro- deal with systemic risks. Progress has already prudential analysis is effectively “translated” into been made to rectify this problem. For example, practical proposals to address emerging risks. recent months have seen the reconstitution of The IIF has previously proposed establishment the Financial Stability Forum as the FSB, the of a Global Financial Regulatory Coordinating enhancement of its mandate, and the expansion Council made up of central banks and super- of its membership. The role of the International visors and responsible to the FSB, and continues Monetary Fund (IMF) has been expanded and the to believe that this would be helpful. importance of the IMF–FSB nexus emphasized. Whatever institutional form is adopted, what is important is the ability to bring a focused and Some Industry Steps technically complete analysis to bear in devel- oping policy proposals for giving effect to macro- The industry fully shares the view that this is prudential concerns identiﬁed by the IMF and a key area for signiﬁcant attention. The IIF’s others.23 The newly mandated FSB is an essential MMG, under the cochairmanship of Jacques de ﬁrst step, but it is likely that its resources will need Larosière and David Dodge, and consisting of to be augmented to achieve these goals. seasoned experts from across ﬁnancial markets In this section we focus on a few aspects of and sectors, will consider market developments, ﬁnancial stability and macroprudential oversight. vulnerabilities, and potential dynamics giving rise to systemic risk in the form of mispriced assets, 23 We note the reasoning contained in the European crowded trades, concentration risk, or emerging Commission’s communication of May 27, 2009, risks of which the industry must be aware.22 It on European ﬁnancial supervision: that individual will explore ways to mitigate such risks, and share ﬁnance ministries should not be included in the its concerns and views with ofﬁcial-sector bodies, European Systemic Risk Council (ESRC) as this in an effort to strengthen systemic soundness. could be perceived as blurring its role in providing independent technical analysis of macroprudential 22 See www.iif.com/press/press+99.php. risks. Institute of International Finance • July 2009 ■ 55 All Systemically Relevant Entities to Fall Commitment XIV: The IIF’s recently- Within Macroprudential Oversight established Market Monitoring Group is committed to identifying and assessing While the goals, means, and implications of systemic vulnerabilities and issues emerging ﬁnancial stability oversight and regulation need in the markets. It stands ready to discuss such much further consideration, certain aspects developments with the ofﬁcial sector. already can be identiﬁed. Financial stability is not a ﬁxed or static Recommendation 28: Macroprudential concept; it is rather the ability of the whole matrix analysis at the international level will need of ﬁnancial entities and relationships, products, to be translated into actionable measures for and infrastructure to support economic activity, implementation. Given the G-20’s mandate manage risks, and absorb shocks on an ongoing to the FSB, the FSB’s resources should be and reasonably predictable basis, without major augmented for this purpose. disruption or discontinuity. Effective regulation and oversight must be designed and developed having regard to the continually evolving and multifaceted nature of the risk. 4.2. SYSTEMIC RELEVANCE Oversight must extend, therefore, not An Important Consensus for Change only to ﬁnancial ﬁrms but also to markets and products, risks, and incentives. The IIF has The G-20 leaders agreed at their April 2, 2009, taken the position that all market participants meeting that all systemically important ﬁnancial whose activities could materially affect systemic institutions, markets, and instruments should be stability should fall within the framework subject to an appropriate degree of regulation of macroprudential oversight, including all and oversight. In particular, the leaders agreed signiﬁcant ﬁnancial markets, products, and risks. to amend their regulatory systems to ensure In respect to ﬁrms, this should apply regardless authorities are able to identify and take account of of legal nature or form of license. Oversight and macroprudential risks across the ﬁnancial system information gathering, of course, need to be and to limit the build-up of systemic risk. They distinguished from more substantive forms of said that large and complex ﬁnancial institutions direct regulation. require particularly careful oversight given their systemic importance. A Question of Degree in the Systemic This theme has been widely echoed in, for Relevance of Firms example, the de Larosière Group report, the Turner Review, and the recently published U.S. Systemic relevance is a question of degree and Treasury proposals. relates to a spectrum of potential impacts of The IIF agrees that ﬁnancial stability oversight failure. It is thus not a binary question whether a needs signiﬁcant enhancement. Risks developed particular ﬁrm should be categorized as “systemi- in the system that neither the industry nor cally relevant” or not. The manner in which ofﬁcial-sector participants were in a position to the failure of different ﬁrms could give rise to manage. It is essential that for the future a full systemic effects takes a wide variety of forms. complement of macroprudential and ﬁnancial For example, some ﬁrms may be neither stability oversight techniques be ﬁrmly in place— particularly large nor highly interconnected with from surveillance and risk identiﬁcation, through the overall system. Nonetheless, they can have analysis and dialogue, to tools for intervention. a material degree of systemic relevance owing to a concentrated role in particular markets or 56 ■ Restoring Conﬁdence, Creating Resilience products or to the impact that their failure would interconnectedness should be developed so have on conﬁdence. Similarly, as discussed in that well-adapted mitigating techniques can Sub-section 2.3, it is important to differentiate be put in place. A tendency to see systemic appropriately between different activities such as risk mainly through the prism of a certain banking and insurance which give rise to varying number of large ﬁrms would not be the risk proﬁles. most conducive to achieving this. The establishment of a formal category of Many of the concerns associated with institutions deemed systemically relevant— systemic relevance can be mitigated through whether public or not—would be unlikely to addressing the interdependencies of ﬁrms produce positive outcomes. It would inevitably in the market. Thus, central counterparties be drawn either narrowly—thus giving rise to and improvement of regulation for many undesirable rigidities and incentives to manage OTC products, reinforcing payment systems, around boundaries, and other unintended and managing interbank exposures through consequences—or broadly so as to undermine its large-exposure limits, all of which are being meaningfulness. Moreover, developed in relevant jurisdictions, will do much more than conceptually and techni- The fact of the deﬁnition of such a category cally difﬁcult limits on a deﬁned category of would tend to reinforce the impression that ﬁrms. the main sources of systemic risk had been identiﬁed and were being controlled. This could lull the markets and contribute to the Systemic Relevance of Firms Key Issue tendency in benign periods to underestimate for Supervisors risks. Although sharp or formalistic deﬁnition of a Risks would tend to migrate away from this category of systemically relevant ﬁrms is likely to category of ﬁrms to other, perhaps less-well- be counterproductive, as discussed in Section 2 a understood or -controlled holders. Such risk-based approach including systemic risk is an dispersion would not mean that the risks essential component of high-quality supervision. had been reduced or eliminated, but it could It is necessary for supervisors to develop a clear contribute to underestimation of risk in the understanding of the degree to which, and the system. manner in which, any particular ﬁrm can pose Perception of ﬁrms formally categorized a threat to systemic stability, either individually as highly systemically relevant would be or collectively with others. Supervisors should distorted. They would likely be seen as tailor their approach to supervision, including considered ofﬁcially too big to fail and as its intensity, having regard to such analysis and beneﬁting from some form of implicit state understanding. guarantee thus increasing moral hazard. The IIF welcomes the fact that the IMF, in By reducing market discipline, this would consultation with the FSB and the Bank for render the system less, not more, resilient. International Settlements (BIS), is developing Identifying and obtaining a clear under- common international framework and guidelines standing of systemic relevance in all its to help authorities deal with the question of varieties and forms is essential. The most the scope of ﬁnancial stability oversight and important reason to do so is to ensure that regulation and the intensity of risk presented. We the most effective means to mitigate such look forward to engaging with the IMF, FSB, and risks are in place. A multifaceted under- other organizations as this process advances. standing of the many forms and features of Institute of International Finance • July 2009 ■ 57 Information and Power to Intervene The IIF agrees that how to address the risks associated with the existence of very large It is essential that those responsible for ﬁnancial participants is an issue that requires consider- stability oversight have access to all relevant and ation. However, the solution lies in a number material information to permit them to carry out of approaches rather than in any one measure risk identiﬁcation and analysis. They should have focusing on the variable of size. the power to bring sources of newly identiﬁed There appears to be an emerging, but not yet risks within the scope of direct regulation, subject, universal, consensus among the ofﬁcial as well as of course, to due process and deliberation. the private sectors that it would be very difﬁcult There is, however, concern that, perhaps and ultimately undesirable to seek to limit the size understandably in the immediate circumstances, of particular ﬁrms. supervisors often request very large amounts of Even if putting a priori limits on ﬁrm size information from ﬁrms without it being wholly were achievable, there is a real possibility that the clear how this information can, in fact, be assimi- systemic risk associated with large entities would lated and used and for what purpose. It is very simply come to reside in a number of smaller but important that information gathering be useful, interconnected entities that would have become proportionate to the ends in view, and based to in effect “large by network” rather than by the maximum extent possible on consistent inter- corporate structure. national reporting formats and requirements. Similarly, we do not consider that the case has been made for “narrow bank” or “new Glass– Commitment XV: The IIF agrees that Steagall” business restrictions on certain banks authorities will require access to all relevant (generally those with access to deposit insurance and material information to carry out effective and central bank liquidity), as has been recently ﬁnancial stability oversight. The industry will suggested by some. work with regulators to identify and provide such information. Beneﬁts of Large, Diversiﬁed Banks Recommendation 29: It would be As discussed in Section 1, signiﬁcant beneﬁts counterproductive to create a formal or come from large, cross-border banks engaging in published category of highly systemically a range of activities. relevant ﬁrms. Systemic risk does not reside Such institutions play a key role in supporting in single entities but in the interconnectedness a globalized economy. They make a signiﬁcant of ﬁrms, markets, and players. It is a rapidly contribution to ensuring diversity of choice for evolving and multifaceted concept that should both investors and users of funds and facilitating be addressed using appropriately sophisticated the efﬁcient transfer of funds from countries with and adaptive techniques, which avoid “excess” savings to locations in need of funds. distortions and moral hazard. Large, globalized commercial and industrial ﬁrms beneﬁt from large, global ﬁnancial partners that they can rely on for sophisticated, high-value 4.3. ROLE OF LARGE BANKS services on a consistent basis. Requiring them to shift to smaller providers would certainly increase Closely related to the issue of systemic relevance the cost and complexity of their business. is the question of whether some ﬁrms are so large Large, well-managed banks make an that they pose an unacceptable risk. “Too big to important contribution to systemic resilience. fail” has become a subject of intensive interna- In circumstances in which external markets are tional discussion. 58 ■ Restoring Conﬁdence, Creating Resilience under pressure, the “internal capital markets” of IndyMac were casualties with perceived systemic such institutions can continue to provide capital impact as the crisis developed. and liquidity in places where it is badly needed. As is stated in the UK Treasury’s proposals Reforming Financial Markets, “there is little Artiﬁcial Restrictions Not the Answer evidence to suggest that artiﬁcial restrictions on a ﬁnancial institution’s size or complexity, The IIF concludes on the basis of members’ including introducing a distinction between experience that the artiﬁcial restrictions that have commercial and investment banking activity, been suggested by some would deprive the global would automatically reduce the likelihood of ﬁrm economy of the beneﬁts provided by large, diver- failure....” 24 siﬁed institutions. At the same time, such restric- During the recent crisis, many groups found tions would not make a positive contribution to resilience in diversiﬁed business models, and the resilience of the system or to ongoing stability. one of the most successful national responses Indeed, the unintended consequences of (Canada’s) was based on resilient universal banks. such restrictions, which would inevitably warp By requiring certain activities to be carried out incentives, would be severely deleterious. Risk elsewhere or size to be limited, such natural distributions would likely become distorted resilience would be lost. and more difﬁcult to identify and manage. The Moreover, while a number of large ﬁrms as overall resilience of markets founded on robust well as small ones found themselves in difﬁculties competition between well-managed ﬁrms would during the recent period, it was other large ﬁrms be undermined, as might be the capacity of that were in a number of important cases called ﬁrms to invest in further development of risk on to play a key role in the safe resolution of management. less-well-managed ﬁrms that were on the brink of As discussed above, systemic risks do not failure. reside simply in single large entities but rather Moreover, there would be considerable in the full constellation of interconnected ﬁrms, practical difﬁculties in the imposition of global markets, and products. As was pointed out by the size or business-model restrictions. It would be de Larosière Group, signiﬁcant risks can arise as a very difﬁcult, if not impossible, to determine result not of the failure of one large ﬁrm but from the appropriate size limits and to implement the common exposure of many ﬁnancial institu- them as ﬁrms approached the limits. As for tions to the same risks. It would therefore be activity restrictions, to proscribe certain activities mistaken to believe that the problem of systemic would be likely to signiﬁcantly hamper ﬁrms in risk can be addressed by limiting the size or providing a reasonable range of expected services activities of ﬁrms. to their client base and would certainly restrict For example, many of the systemic events the future pace and scope of innovation within of recent times were triggered by problems in the environment of sound risk management that institutions that would not be considered particu- well-managed and well-supervised large ﬁrms can larly large. Trust and conﬁdence are two essential provide. ingredients of a functioning ﬁnancial system, and It is important to the future success of once these are undermined, events can unfold the global economy that the ﬁnancial services very quickly, irrespective of which particular industry be run both soundly and proﬁtably. This institutions trigger events. This was clearly shown means that leading participants need to be able to in the current crisis, in which comparatively small engage in a range of activities covering a variety or “narrow” institutions such as Northern Rock, of risk types. In addition, ﬁrms’ ability to partic- IKB, Sachsen Landesbank, Hypo Real Estate, or 24 July 2009, p. 74. Institute of International Finance • July 2009 ■ 59 ipate in markets and take positions is important Moreover, as discussed above, the IIF supports to their ability to support the economic activity a risk-based approach to supervision, where the of real-economy businesses. To limit the ability determination of risk involves weighing both the of ﬁrms to engage in well-managed proprietary probability of an event and its likely impact. It is activities is likely to have a very distorting effect both desirable and appropriate for supervisors to and ultimately to hinder a return to full ability to give a central role to systemic risk in the deter- serve clients and maintain markets. mination of their approach to the supervision of a particular ﬁrm. It should be expected that the Better Solutions supervision of a ﬁrm will be more intensive where the failure of the ﬁrm would have a material The presence of large, diversiﬁed, cross-border impact on the system. institutions brings many beneﬁts to the global In general, while it may be appropriate to economy and to individual countries and their apply more intensive supervision to larger ﬁrms, citizens. As imposing artiﬁcial limits on size for the reasons discussed above we do not believe or activities would be harmful in practice and that it is appropriate to apply different regulations unlikely to succeed in reducing overall levels of to ﬁrms purely based on the size or because they systemic risk, the question becomes how best to are determined to fall within a predetermined address the problem of the potential impact of category of high systemic relevance. the failure of such institutions (and, indeed, other However, in accordance with a risk-based institutions of systemic importance). approach to supervision, it is appropriate for supervisors to take into account the degree of Improved Risk Management systemic relevance of a ﬁrm in carrying out its First, large, diversiﬁed, cross-border institutions supervisory review of the ﬁrm. This means that must achieve a very high degree of soundness, supervisory measures applied to a ﬁrm including, stability, and quality of risk management. With for example, requirements to improve risk the publication of the IIF Market Best Practices management or, ultimately, to require additional Report last year, the industry collectively began the capital, should legitimately take account of the task of achieving higher quality risk-management systemic impact of such a ﬁrm should it fail. standards across the piece. Work is continuing strongly across the industry to implement the Commitment XVI: The IIF agrees that the recommendations in that report (see Section 2). degree of systemic relevance of a ﬁrm may The standards set out in the report have become require more intensive supervision. Members widely accepted as sound standards of risk are committed to working with supervisors to management and have become an important part make such an approach effective. of supervisors’ dialogue with ﬁrms. Commitment XVII: The IIF agrees that the supervisory review process applied to Enhanced Regulation and Supervision ﬁrms should be founded on a risk-based The range of regulatory reform that is under approach. Accordingly in determining what way will make a signiﬁcant contribution to if any supervisory measures should be taken, ensuring high levels of soundness and quality of supervisors should incorporate analysis of the risk management in large banking institutions. nature and degree of a ﬁrm’s impact on the Key aspects of this regulatory reform agenda are system should that ﬁrm fail. Members are discussed in Section 3 of this Report, and we do committed to working with supervisors to make not repeat them here. such an approach effective. 60 ■ Restoring Conﬁdence, Creating Resilience More Resilient Infrastructure Contingency Planning for Insolvency Recent history shows that the interconnectedness Experience with the Lehman Brothers failure of ﬁrms in global markets is much more a cause in particular has shown that insolvency of a for concern than size or business model as such. It large and complex ﬁrm operating in multiple is possible to enhance the resilience of the system jurisdictions poses many technical as well as legal as a whole, including its interconnectedness, by problems. This has in turn suggested that the task improving infrastructure so as to make it much of the administrators and regulators coping with less prone to instability and risk contagion in the the aftermath of a failure would be made easier event of the failure of a large ﬁrm. The progress and the process more orderly if there were more that has already been made by the industry and prior planning. the ofﬁcial sector in reducing the level of bilateral Gov. Mervyn King put it that “making a counterparty exposure arising from credit will should be as much a part of good house- derivatives and from OTC derivatives generally keeping for banks as it is for the rest of us.”25 through the increased use of CCP techniques is It is debatable whether this analogy is tenable a good example of this. Work should continue for a large, ongoing business. It is more likely over the coming months to consider further to be productive for ﬁrms to examine with the improvements that might be made to reduce authorities the risks that their roles in markets systemic risks arising for infrastructural and and products create, so as to help the authorities interconnectedness reasons. Similarly, the risks assess what would happen in event of their failure. of securitization markets are now much better Moreover, given the objective of making failure understood, and the structures for simpler, more a realistic threat, the ongoing dialogue between transparent, and more liquid markets are already large ﬁrms and their authorities should include being developed (see further Section 5). consideration of all the information necessary to plan for the orderly exit of the ﬁrm should that Making Orderly Exit Possible prove necessary. Such planning should be developed in close As already discussed at Sub-section 2.4, the collaboration with supervisory colleges. The IIF plausible threat of loss is the foundation of ﬁrmly believes that for such an approach to be market discipline. An important part of making successful, it is essential that such dialogue be it credible that investors and creditors of a major carried out in conﬁdence between the ﬁrm and ﬁrm would suffer the consequences of failure its relevant authorities. Public disclosure could will be to put in place signiﬁcantly enhanced undermine stability by giving market counter- procedures and mechanisms for dealing with parties a road-map to the ﬁrm’s intentions, ﬁnancial crises, in particular cross-border crisis, facilitating the taking of positions against it. and for the winding-up of large or systemically In summary, therefore, the too-big-to- important institutions. The essential goal is to fail question is a legitimate one for debate. make it feasible for such institutions to fail in The solution lies not in ﬁat limits on size a non-disruptive fashion, that is, to be able to but in a range of measures designed ﬁrst to exit the market in an orderly and reasonably ensure soundness and the highest quality risk predictable manner (see Sections 6 and 7). management in such ﬁrms and second to make it more practicable for major ﬁrms to exit the market in an orderly manner, should that prove necessary. 25 Mansion House Speech, June 17, 2009. Institute of International Finance • July 2009 ■ 61 Recommendation 30: Artiﬁcial restrictions on 4.4. MICROPRUDENTIAL size or diversiﬁcation should be avoided. Large, SUPERVISION complex institutions play an important role in As discussed in Section 2, developing effective supporting the global economy. Restrictions on techniques for the microprudential supervisory size or diversiﬁcation could produce materially implementation of macroprudential oversight distorting effects and unmanageable risk is a signiﬁcant challenge. The new task of incor- patterns within the system. The industry agrees, porating macroprudential analysis and insights however, that in addition to ensuring that such into the microprudential supervision of ﬁrms institutions meet the highest standards of risk will require an outcomes-focused, risk-based management, it is essential that they be subject approach that creates incentives for strong risk to effective market discipline. To this end, there management. should be developed the infrastructural, legal, and process reforms necessary to ensure that all Global Supervisory Colleges ... Role of ﬁrms can exit the market in an orderly fashion the FSB without causing undue trauma to the system. As discussed in Sub-section 1.3, group-wide Recommendation 31: Restrictions on the effective and efﬁcient supervision, in both the business models or range of activities of ﬁrms macro- and microprudential dimensions, requires should be avoided. While it may be appropriate integration, ideally seamlessly, of supervisory to require additional capital in respect of activities and macroprudential analysis across higher risk activities, there is no good case to all relevant regulators. The smooth operation prevent ﬁrms from engaging in a full range of of global supervisory colleges is crucial, and the ﬁnancial activities in accordance with sound industry welcomes recent progress that has been and well-managed business models. Far from made in this regard under the leadership of the being a source of vulnerability, diversiﬁed, well- G-20. managed, and proﬁtable ﬁrms provide a source In order to ensure the effective “bridging” of of real resilience for the overall system. macroprudential oversight and microprudential Commitment XVIII: Consistent with the practice, the FSB should do the following: principle that no ﬁrm should be designated too big to fail, large or highly interconnected ﬁrms • Develop and regularly review joint interna- should examine with the authorities the risks tional strategies that set the macroprudential that their role in markets and products create, to framework for the supervisory activities at help the authorities assess what would happen the microprudential level; in event of their failure. The ongoing dialogue • Implement these strategies through between such ﬁrms and their authorities should coordinated horizontal and, as appropriate, include consideration of all the information thematic work across the peer group and necessary to plan for the orderly exit of the ﬁrm across the responsible national micropru- should that prove necessary. dential regulators; and • Ensure close coordination and cooperation Commitment XIX: Riskier activities should be within and, importantly, consistency across subject to appropriately risk-weighted capital the supervisory colleges set up for the requirements. Such capital requirements should multinational ﬁrms in the peer group. be calibrated so as to reﬂect the risk of those activities and consideration should also be given In addition, it will be necessary for colleges to relevant cost of funding issues. to look to the efﬁciency and consistency of the 62 ■ Restoring Conﬁdence, Creating Resilience regulatory process across each group, for example established an industry platform representing on reporting and Pillar 2 analysis. the large European banking groups subject to college-based supervision. This platform interacts Recommendation 32: The FSB should directly with a Committee of European Banking coordinate the engagement of supervisory Supervisors (CEBS) sub-group mandated to colleges in the implementation of the policy help coordinate college-based supervision of the conclusions arising from macroprudential participating banking groups. oversight and analysis, as well as in the A similar platform representing the multi- assessment of emerging ﬁnancial stability risks. national ﬁnancial institutions for which global supervisory colleges have been established would provide feedback on the microprudential operation of the global colleges. It could help Interaction with the Industry communicate and implement the FSB’s macro- The IIF stands ready to contribute via its MMG prudential strategies into the microprudential (see Section 4) to the FSB’s macroprudential activities of the global colleges across the peer analysis and the formulation of international group. Signiﬁcant added value could be expected strategies setting the macroprudential framework in particular from the interaction and cooper- for the microprudential activities of the global ation with the industry platform in relation to the colleges. The MMG would be well placed to bring horizontal, thematic work of the global colleges. to the fore the industry’s view on systemic vulner- abilities and cyclical risks. It also could draw Recommendation 33: To achieve the FSB’s attention to possible improvements of macroprudential aims effectively and market practices and infrastructures. efﬁciently, a structured international dialogue In contrast, the implementation of strategies should be put in place between authorities through microprudential activities and the and ﬁrms. This should involve an industry day-to-day operation of the global colleges will platform, representing ﬁrms subject to FSB warrant a separate dialogue with the industry. colleges and the supervisors involved in those The FSB may wish to consider replicating the colleges. approach taken in the EU, where there has been Institute of International Finance • July 2009 ■ 63 SECTION 5 Improving Market Infrastructure and Mitigating Risks of Interconnectedness 5.1. BENEFITS AND RISKS did not. Owing in part to the identiﬁcation of potential weaknesses and action taken over recent A wide range of factors contributed to the years, key components of the system in fact emergence and rapid deepening of the ﬁnancial showed signiﬁcant resilience through the past 18 crisis, acting in combination. No one or two on months. their own would have caused the damage that has It also is important to remain sharply focused occurred. on the precise nature of the vulnerability that The global ﬁnancial services system has a measure is intended to address. For example, become highly interconnected in a rich variety of requiring a product to be largely cleared by a ways. These include a dense and complex infra- CCP has a different purpose and will achieve structure for entering into and processing trans- very different outcomes from a requirement actions and for handling assets, a signiﬁcantly that it be exchange traded, yet the two issues of enhanced ability to parse and transfer risk around central clearing and exchange trading have often the system, the enormous number and complex been conﬂated and confused in the course of the conﬁguration of direct and indirect connections debate. It is important to keep remedies focused between market participants, the emergence on the ills they are meant to cure. of correlated exposures to risks not previously understood, and a system-wide increase in speed of change of asset values. 5.2. MARKET INFRASTRUCTURE Such interconnectedness brings many beneﬁts Robust market infrastructure is as important to the global economy and thus to welfare across as a strengthened regulatory and supervisory the world. However, it also is clear that such inter- system. Important global wholesale markets and connectedness carries signiﬁcant risks and that their supporting infrastructures have stood the these risks have been neither fully understood test of this crisis. OTC market infrastructure and nor well managed in the period leading up to the payment, clearing, and settlement systems have ﬁnancial crisis. on the whole demonstrated good robustness The IIF regards it as important that measures and largely normal operation throughout the be put into place that will retain the beneﬁts of an crisis. The default of Lehman Brothers, despite its interconnected and sophisticated global ﬁnancial wider impact, was handled without untoward or system while reducing the risks to acceptable unpredictable impact on clearing and settlement levels. systems, and settlement of related derivatives It is important to be clear about precisely transactions generally functioned as intended. which parts of the system have shown vulner- Many wholesale products, CDS included, abilities, or may be prone to doing so, and which cannot be blamed as main drivers of the crisis per Institute of International Finance • July 2009 ■ 65 se. However, they did play a contributory role, in 2005, the industry, through the Operations particular as a means of loss transmission and Management Group, has been closely engaged through heightening of uncertainty concerning with supervisors in a range of initiatives to the potential damage to credit quality of market improve risk management, processing, trans- participants. In certain markets, the absence of parency, and the systems and procedures for transparency contributed to the expansion of carrying on OTC derivatives business. Over the opaque counterparty exposures across the system. recent period, this effort has continued at an Signiﬁcant enhancements can be achieved in increased pace. order to strengthen both market efﬁciency and The industry and infrastructure operators, in ﬁnancial stability. line with agreements with regulators, have collec- In addition, it is clear that where market tively begun the process of centralized clearing participants engaged in signiﬁcant levels of of CDS trades. Progress is continuing rapidly in activity in respect to the products for which they both the United States and Europe to broaden had developed neither sufﬁcient understanding and deepen this process. The IIF notes that most nor appropriate risk management ability, losses CDS contracts are already recorded in a trade were likely to occur. repository, Depository Trust and Clearing Corpo- Other types of infrastructure developments ration’s (DTCC’s) Trade Information Warehouse, also will improve the overall resilience of the and that efforts are reaching completion to extend system. Certain of these are now being debated this repository to those contracts not yet so in the ofﬁcial sector but will make a signiﬁcant recorded. difference in the medium term. An example The OTC interest rate swap market already is expanding and making more consistent beneﬁts from a relatively high level of centralized depositors’ expectations from deposit guarantee clearing. There are plans to expand this further in schemes, which will at the same time clarify terms of membership, product, and participation depositors’ risks, the risks of national systems, of the buy-side community. In the equity deriva- and supervisors’ expectations, thereby increasing tives markets, 50% of notional trade is already market clarity as the current extraordinary cleared via exchanges and their associated clearing measures are withdrawn. houses. Similarly, large-exposure regulation will make The global FX market is one of the most a difference to the resilience of the interbank liquid, transparent markets in the world, with market controlling interdependencies. Also a daily turnover of over $3 trillion. Continuous important to control interdependencies is the linked settlement (CLS) ensures payment versus development of CCPs for many OTC products, as payment settlement in central bank funds. Under discussed further in this section. Finally, the IIF this system, the Lehman Brothers’ default was is convening an infrastructure group to look at handled smoothly, with few FX deals where additional ways to improve resilience and better Lehman was a counterparty being rescinded. manage interconnectedness, including in cash However, the possible role for a CCP backed up and securities settlement systems. by a default fund should be considered. A CCP solution could cover the replacement risk on Progress Made forward contracts, currently not covered by CLS. It is important, however, in general, to avoid Major progress has been made and continues unintended consequences in areas where the to be made in improving the operation of the market has been shown to be working well. OTC derivatives market, including CDS. Since 66 ■ Restoring Conﬁdence, Creating Resilience In June of this year, members of the industry entered into a number of further commitments Commitment XX: In line with the concerning the operation of these markets. commitments already made by industry This included a commitment in respect of all participants, and reiterated in the industry trades that are not cleared through a CCP to letter of June 2, 2009, to the President of universal recording of CDS trades, interest rate the Federal Reserve Bank of New York, derivatives trades, and OTC equity derivatives and building on ongoing progress, industry trades in a trade repository to be achieved over is committed to CCP clearing of eligible identiﬁed timescales. The IIF fully supports this standardized CDS contracts and OTC commitment. transactions. Commitment XXI: In line with the continuing Standardization work of the International Swaps and Derivatives As stated, robust centralized clearing of trades Association (ISDA), standardization of CDS can reduce signiﬁcantly systemic risks and should and other OTC contracts should be pursued to apply to eligible standardized OTC derivative an appropriate degree. products. Recommendation 34: It is important, At the same time, it is important to note however, that end-users of CDS and other that bespoke OTC derivatives are vital for the OTC contracts remain able to effectively risk management and hedging needs of the real hedge against speciﬁc situations. Accordingly, economy. A move to fully standardized products standardization should not be pursued to would come at the cost of much less-effective the extent that it eliminates the ﬂexibility risk hedging. Clients would be prevented from achievable by the continuing availability of utilizing hedge accounting techniques, resulting bespoke transactions. in increased earnings volatility and potentially increased risks. Striking the right balance is Recommendation 35: Authorities’ crucial in order to preserve the signiﬁcant beneﬁts intervention in the CDS and OTC markets bespoke OTC derivative products offer to the real should be strongly coordinated internationally. economy. The market is international, and the The market for CDS and other OTC establishment of artiﬁcial boundaries should be derivative contracts is international. Its interna- avoided. tional nature provided many beneﬁts in terms of both the depth of markets and the ability to hedge risks. Authorities should ensure that their Managing Risks of Increased Use of Central initiatives are coordinated internationally so as Counterparties not to introduce distortions. They also should avoid artiﬁcially fragmenting markets so that they It is of great importance that central counter- become less effective and efﬁcient and, ultimately, parties be operated under robust risk manage- less resilient. The industry should ensure ment frameworks. Systemic risk will not be that standardization efforts are coordinated reduced and may, indeed, increase if poorly set internationally. up clearinghouses are allowed to proliferate and risk management standards allowed to erode. It is important that risks not be increased by requiring clearinghouses to deal with contracts that do not meet their systems, liquidity, or other general requirements. Institute of International Finance • July 2009 ■ 67 Changes to risk management standards to note should be taken of the conﬁdential nature allow lower margin levels should be monitored of transactions between buyer and seller and the carefully. Furthermore, clearinghouses should likely detrimental effect on liquidity provision not be allowed to offer new products or develop before considering publication of information materially increased ﬂows without having regarding individual transactions (trade developed sufﬁciently robust risk management reporting) to a wider audience. methodologies. Price competition is healthy but A variety of pre-trade price discovery mecha- must not be allowed to lead to reduced standards. nisms for OTC markets already exist, with dealers The process for introduction of new products providing price information for ﬂow products should be overseen carefully by the appropriate to clients during trading hours, including live supervisors. posting of dealable prices. The industry will continue to support the provision of such services Recommendation 36: Systemically relevant going forward, with increased pricing availability infrastructure providers should have access to via electronic systems and greater aggregation of central banks’ emergency liquidity provision. market prices across dealers via electronic multi- dealer trading platforms and making use of data consolidators such as Markit or other providers. Availability of market prices is therefore not Enhancing Transparency, Disclosure, and dependent on a shift of all OTC trading business Price Discovery Mechanisms to an established exchange. Transparency is key for robust, smoothly functioning markets providing reliable price Commitment XXII: In line with the industry discovery mechanisms. The IIF fully supports letter of June 2, 2009 to the President of the increased market transparency and disclosure in Federal Reserve Bank of New York, to the OTC derivatives through widespread transaction extent that CDS contracts, OTC interest rate reporting via regulated transaction repositories derivative trades, and OTC equity derivative to the relevant regulatory authorities. This trades are not subject to CCP clearing, they transparency will assist in regulatory oversight will be recorded in a trade repository to ensure to prevent market abuse and manage concen- appropriate transparency of the market. tration risk. Transaction reporting already is well under way in CDS via DTCC’s Trade Information Enhancing Other Post-Trade Infrastructure Warehouse. The industry is committed to providing transaction reporting to a trade The IIF supports the views expressed by ISDA repository of all credit derivative trades that are in its response to the UK FSA’s Turner Review not subject to CCP clearing. concerning collateral management in the context The IIF fully supports the continuing strong of OTC derivative transactions. Considerable progress toward enhanced levels of transaction progress has been made in this area, including reporting for other derivative transactions as with respect to portfolio reconciliations, metrics agreed in the industry letter of June 2, 2009, to the on position and market value breaks, and President of the Federal Reserve Bank of mechanics for dispute reconciliation. We welcome New York. and support the objective of developing a As pointed out in the International Swaps “best practices” document to be published by and Derivatives Association (ISDA) response June 2010. to the Turner Review of June 18, 2009, however, 68 ■ Restoring Conﬁdence, Creating Resilience Enhancing Payment Infrastructure establishing a work program to look further into infrastructure aspects of this issue. The Institute As noted before, the existing payment infrastruc- looks forward to engaging with the ofﬁcial sector tures operated successfully, including around the as the work proceeds. failure of Lehman Brothers. Volumes and values processed remained close to normal, and despite heightened risk management measures, no undue 5.3. RATING AGENCIES frictions or delays occurred. The Market Best Practices Report sets out a This resilience is largely due to the fact that number of recommendations and principles the operation of payment systems is underpinned regarding both the oversight of rating agencies; by a relatively small group of direct participants their own risk management and quality with exceptionally high-quality risk management assurance; and how banks, other ﬁnancial ﬁrms, systems and processes and the willingness to and investors should approach the use of their provide the necessary liquidity even in periods of ratings. severe stress. The IIF believes that the provision of a Key principles are sound intraday limits, reliable mode of communicating issues of credit their monitoring and management on a global quality in a manner that is meaningful between or regional basis with near-time adjustments, market participants remains a matter of central and globally aligned cut-off times (COT), as importance and presents a difﬁcult challenge for well as extensions of payment infrastructures the future. between the central banks and system providers The IIF welcomes and broadly supports the in order to allow payment processing without proposals for the oversight of rating agencies frictions throughout and across regions. It will developed by IOSCO and the EU, among be important to ensure that these principles are others. However, we note that in this area there given ongoing robust effect. has not to date been a strong commitment to An area that displayed vulnerability and acted international coordination by all parties. This as an ampliﬁcation mechanism was the interbank lack of commitment carries a continuing risk of funding market. A sudden and widespread loss of achieving sub-optimal outcomes. market conﬁdence contributed to a chain reaction While welcoming in general terms the devel- involving banks, money market funds, and other opment of these new approaches to the oversight ﬁnancial-sector participants in a difﬁcult-to- of rating agencies, the Institute contends that, arrest spiral of fear and withdrawal. As the market despite the good work done by IOSCO and contracted, prudent risk management on the part others, there should be a special role for the of individual ﬁrms, guarding liquidity in case of Basel Committee in setting high-level standards need or in case of their own funding difﬁculties, for ratings agencies recognized for bank capital contributed to a seizing up of the market at all purposes. In particular, we believe that the Basel but the shortest maturities. Committee and bank supervisors should set It is therefore desirable to consider the additional standards for the quality of processes operation of the interbank markets and whether of model validation and monitoring in rating techniques may be developed to render them agencies. Amplifying the discussion in the Market more resilient to this type of chain reaction effect. Best Practices Report, the IIF has suggested to The IIF’s published work on liquidity, the Basel Committee that it develop further including a major report in 2007 and the standards for the quality of processes of model Market Best Practices Report of 2008, addressed validation and monitoring in rating agencies, and the liquidity-speciﬁc question. Now the IIF is has proposed independent veriﬁcation of rating Institute of International Finance • July 2009 ■ 69 agency processes of model validation, governance, securitization markets and place them on a and monitoring, perhaps to be implemented by sound footing for the future. The IIF strongly a self-regulatory organization or independent supports the efforts being made in that direction, international review body. in particular the Global Joint Initiative to Restore Conﬁdence in the Securitization Markets of the Recommendation 37: The Basel Committee American, European, and Australian Securiti- should develop further standards for sation Forums and the Securities Industry and model validation and monitoring in rating Financial Markets Association.26 agencies, especially for structured products. Closely related to issues of improving the There should be independent veriﬁcation of transparency and viability of securitization is the rating agency processes of model validation, question of transparency of ﬁrms’ off-balance governance, and monitoring by means of a self- sheet exposures. The Institute and other associa- regulatory organization or a new independent tions have worked with the Basel Committee on international review body. developing new Pillar 3 guidelines on off-balance sheet exposures, and on propagating under- standing of the new disclosures in the market. Among the measures that have been 5.4. TRANSPARENCY developed by the industry are the European The 2008 Market Best Practices Report also Securitisation Forum’s RMBS Issuer Principles identiﬁed increased transparency as key to for Transparency and Disclosure,27 a set of recom- both the restoration of conﬁdence and the mendations targeted at issuers of European maintenance of stability for the future. Achieving residential mortgage-backed securities (RMBS). optimal levels of effective transparency remain The American Securitization Forum has central to both a stable and effective market established Project RESTART,28 which seeks to infrastructure and to mitigating the risks of a reduce the opacity in securitization markets by highly interconnected system while retaining the developing detailed recommendations for greater beneﬁts. transparency, disclosure, and due diligence. By We have discussed above the ongoing progress making data more accessible, such efforts will that is being made in achieving increased trans- help investors distinguish poorly underwritten parency in respect of OTC derivative markets, loans from higher quality pools and create greater including CDS. market discipline and more accurate valuations. Another crucial area for the development Taken together, these developments of enhanced transparency is the securitization represent signiﬁcant advances ensuring that, markets. As discussed in Sub-section 3.1, securi- both pre-issuance and post-issuance, investors tization, at least in its less-complex forms, has and supervisors are able to obtain meaningful, been essential to the provision of credit of many comparable, and effective information to important types such as automobile ﬁnance, underpin robust risk assessment, measurement, student loans, credit cards, and the familiar and management in respect of securitized types of mortgages. However, the absence of products. transparency in respect of certain types of struc- 26 See Restoring Conﬁdence in the Securitization tured products lay at the heart of the crisis. The Markets, December 3, 2008, and related publications. industry is fully committed to transformation 27 December 2008. of this situation in order to restore important 28 See www.americansecuritization.com/restart. 70 ■ Restoring Conﬁdence, Creating Resilience There are, of course, also important regulatory initiatives in this area. These include Recommendation 38: The industry and the IOSCO’s Consultation Report on Unregulated ofﬁcial sector should continue to work together Financial Markets and Products.29 The industry to build on the new foundations already is closely engaged with the ofﬁcial sector to developed to ensure high levels of transparency optimize the results of such efforts. for securitization products and markets so that securitization can continue to play its important role in providing ﬁnance for key 29 May 2009. asset classes. Institute of International Finance • July 2009 ■ 71 SECTION 6 Resisting Fragmentation of International Markets S ection 1 sets out the beneﬁts of an integrat- standing commitment to greater ﬁnancial services ed international market in ﬁnancial services integration in a single European market. and the importance of enhanced coordi- nation between authorities in the regulation of Regulatory Self-Sufﬁciency Measures those markets. Proposals that are grounded in national regulatory authorities’ seeking to limit the 6.1. FRAGMENTING MEASURES damage to national stakeholders in the event of a As discussed there, recent months have seen ﬁrm or market failure by requiring local market considerable levels of coordination led by the self-sufﬁciency have a strong appeal if looked at G-20 and reﬂected in the enhanced mandate from a national perspective only; however, they of the FSB and the heavy work programs of risk undermining the resilience and effectiveness organizations such as the Basel Committee and of the global system. IOSCO. However, despite this progress, including A leading example can be found in the UK the achievement of important agreements at the FSA’s proposals for a new liquidity framework, level of principle by the G-20, other developments including a so-called self-sufﬁciency requirement have been much less positive and have given rise that UK subsidiaries and branches of non-UK to signiﬁcant concern. groups meet liquidity requirements on a stand- alone basis (see Section 3). General Home Bias Measures Similar ring-fencing or self-sufﬁciency approaches are also beginning to be seen Many governmental actions have sought to emerging in other countries. There is no doubt ensure that the beneﬁts of ﬁscal support accrue to that if such an approach is formally adopted each domestic economy, in particular making the by a large jurisdiction signiﬁcant in the ﬁeld of receipt of government support subject to explicit ﬁnancial services it will rapidly be followed by or implicit requirements to support domestic others both as a logical conclusion as to their own clients. defensive needs and perhaps in retaliatory mode. Moreover, even actions designed to promote competition have lent themselves to the de facto Regulatory Non-coordination reinforcement of home bias. The European Commission’s responses to review of state aid to In recent months there have been a number speciﬁc businesses tend to require focus on “core of examples of national or regional non- business,” which may lead to retreat to home coordination in the development of new regula- territory, to the detriment in particular of Eastern tory standards. This is doubly regrettable, as there Europe. This approach is at odds with the long- has never before been so much consensus as to Institute of International Finance • July 2009 ■ 73 the need for regulatory reform and such strong Lessened Resilience momentum to achieve reform in a coordinated The adoption of a ring-fencing approach, while manner. Failures of coordination have incurred in it may give additional immediate comfort to any respect of proposals for securitization reform, for given jurisdiction, is likely to render the overall the oversight of rating agencies and hedge funds, system less resilient, both in terms of groups’ for credit derivatives markets, for the control of ability to marshal resources to meet large needs short-selling, and for the regulation of liquidity and in terms of their ability to respond to crises. risk management. The direct costs associated with a widely adopted ring-fencing approach will be neither Extraterritoriality modest nor moderate—nor fully predictable until In addition, the U.S. Treasury’s Financial the full scope of fragmentation can be appre- Regulatory Reform proposals30 to extend criteria ciated, by which time much will be lost. for identifying Tier 1 ﬁnancial holding companies As compared with a top-down perspective (FHCs) to foreign ﬁrms—including considering whereby the prudential situation of a group is “applying the criteria to the worldwide opera- considered as a whole, the cost of a bottom-up, tions of the foreign ﬁrm”—raise concerns as jurisdiction-by-jurisdiction approach adopted to multiple systemic stability regimes with across the full gamut of regulatory requirements signiﬁcant overlap, with additional complexity is likely to be very substantial. created by extraterritoriality in lieu of interna- tional cooperation. Danger of Ill-Considered Cumulative Effects There is a real risk that the overall outcome of 6.2. A CAUSE FOR REAL CONCERN current national responses to the crisis will be However understandable some of these measures a highly fragmented, very inefﬁcient system may be, viewed from the perspective of individual wherein the general levels of capital, liquidity, jurisdictions and given the concern to protect and other prudential requirements are raised, domestic taxpayers, their negative global conse- based on decisions of the international regulatory quences are signiﬁcant, and the net result is a standard-setters, and in addition self-sufﬁciency negative-sum outcome. requirements are imposed, based on bottom-up, It seems clear that self-sufﬁciency approaches, uncoordinated actions by individual jurisdictions. such as that proposed by the UK FSA in respect of It is essential that such an outcome be avoided. liquidity management, will not be limited to a few Paradoxically, the many changes in regulation, jurisdictions. Rather, once adopted by one major supervision, governance, and internal risk jurisdiction, a logical consequence will be that management that are already well started should such measures will be adopted by many if not all make it possible for greater, not less, reliance jurisdictions. on home supervisors. If well designed, these It is difﬁcult to conceive of an enhanced measures will succeed in producing a more global economy delivering strong sustainable resilient system. Failure to take this into account growth across the world on the basis of ﬁnancial in local responses will likely undermine the markets that have become substantially more beneﬁt of all that is being done. inward looking and forced into a nationally Finally, an international approach that self-sufﬁcient mold in the way they are conceived, tolerates fragmentation and does not calculate the regulated, and run. cumulative effects of international and national 30 measures would represent a dramatic change of Financial Regulatory Reform: A New Foundation, June 2009. the general development of the global economy 74 ■ Restoring Conﬁdence, Creating Resilience since 1945. There is a real risk that, over the IMF, particularly in the context of its Article IV coming years, inward-looking, control-driven surveillance and through a consistent, objective, regulation could replace the drive toward the and even-handed Financial Sector Assessment realization of mutual beneﬁts. Despite the clear Program (FSAP) process. intent of the G-20 and FSB to the contrary, there is a danger of a loss of global integration and Recommendation 39: The FSB should, cooperation, as happened between 1914 and together with the IMF, make addressing 1945. Resolute steps should be taken to avoid this. fragmentation of the international ﬁnancial market a permanent objective. This should 6.3. FIGHTING FRAGMENTATION complement the FSB’s important task of ensuring enhanced cooperation and Authorities that adopt inward-looking measures coordination among authorities. face genuine dilemmas resulting not only from political pressures arising from the cost of the crisis but also from the fact that ﬁrms remain “national in death.” Moreover, the difﬁculties Substantive Measures and Steps to Address faced result from deep coordination problems the Conﬁdence Deﬁcit arising from the stage of development of inter- Ultimately, what drives a jurisdiction-focused, national cooperation, wherein much remains self-sufﬁciency approach is failure of conﬁdence on a state-based footing. Such problems cannot in other authorities and in the global market. be fully resolved simply by doing more of what That is, authorities consider that in the event of has been done before, although a return to the the failure or near-failure of a cross-border group, growing cooperation seen until recently could stakeholders in the jurisdiction—depositors, continue incremental progress. Fresh ideas and creditors, the ﬁnancial system, and taxpayers— renewed political determination are necessary. will suffer disproportionately as compared with stakeholders in other jurisdictions. Bodies Taking up the International Challenge It is necessary to take signiﬁcant new actions The FSB’s new mandate includes the responsi- to address this issue. To that end, several recom- bility to promote coordination and to advise on mendations of this Report relate to the estab- how countries perform in meeting regulatory lishment of signiﬁcantly revised arrangements for standards. Members agree, inter alia, to maintain dealing with cross-border crisis management and the openness of the ﬁnancial sector, to adhere to ﬁnancial ﬁrm resolution. These issues are dealt agreed international standards, and to undergo with in detail in Section 7. peer review. The IIF proposes that a further task of the A New Foundation for International FSB should be to monitor regulation or other Cooperation ofﬁcial-sector actions that have a materially Experience in many areas of international fragmenting effect from the global perspective, coordination and cooperation has been that to raise those matters for discussion, and to issue a point is reached at which it is necessary to public reports including alternative suggested establish mutual commitments on objectives and approaches to address the problems motivating principles in order to overcome the coordination national authorities. Fragmentation also could be problems that hinder enhanced mutual reliance. added to the FSB’s peer-review program. In respect of international markets in ﬁnancial In addition, countering ﬁnancial fragmen- services, the world is at such a juncture now. tation can be furthered by the activities of the Institute of International Finance • July 2009 ■ 75 Thus, the time is right for an inter-governmental An accord would make a signiﬁcant accord on ﬁnancial markets and ﬁnancial services contribution to the restoration of conﬁdence in among the G-20. ﬁnancial markets. By expressing agreement on a Such an accord at this stage probably could range of topics currently viewed, perhaps incor- not be a binding international treaty but could rectly, as difﬁcult or divisive, it could rebuild and articulate, at a sufﬁcient level of granularity to reinforce mutual conﬁdence across jurisdictions. create conﬁdence in reliable execution by major Also, it would provide a clear framework countries, the objectives and aims, principles, and within which national authorities could approach parameters agreed to be essential to the ﬁnancial their international responsibilities. For example, it system of each jurisdiction as well as of the global could provide the necessary basis for meaningful ﬁnancial system. This would provide a ﬁrm basis progress on cross-border crisis management, the for enhanced mutual conﬁdence and trust. need for which is discussed in Section 7. Such an accord could provide the impetus to signiﬁcantly enhanced cross-border cooperation Recommendation 40: The point has been including renewed progress on mutual reached where international cooperation recognition. and coordination should be put on a ﬁrmer It would provide a basis of clear expectations footing. We recommend the development of a for authorities’ dealings with each other on cross- non-binding inter-governmental accord on border ﬁnancial services issues. ﬁnancial markets and ﬁnancial services. 76 ■ Restoring Conﬁdence, Creating Resilience SECTION 7 Cross-Border Crisis Management and Financial Firm Resolution Regimes 7.1. A MISSING LINCHPIN include contingency planning for cross-border crisis management. We also welcome the estab- Clear arrangements for the effective management lishment by the FSB of a Cross-Border Crisis of crises affecting large, cross-border institutions Management Working Group. will be critical to restored conﬁdence in and The FSB should develop a comprehensive resilience of a strongly functioning international framework of planning and preparation for market in ﬁnancial services. As the Group of crises and their management. It should put in Thirty report stated, “The most pressing and place a strong regime for the governance of complex of those [needed] enhancements relate crisis management. Building on its position as to making crisis management coordination more a neutral but deeply informed participant, the effective and operational by agreed protocols.”31 FSB should develop a coordination, advisory, and The most effective forms of cooperation non-binding mediation role in the preparation between authorities in the ongoing supervision of crisis management arrangements in respect to of cross-border entities will be difﬁcult to achieve individual groups to help ensure optimal coordi- without an effective and fair mechanism for nation between the authorities directly involved managing and resolving crisis events affecting in a particular crisis. individual institution. A host supervisor is less likely to trust the judgment of a home supervisor if it believes 7.3. GOVERNING ARRANGEMENTS that in a crisis the home supervisor will be led to IN CROSS-BORDER make decisions prejudicial to the interests of the COOPERATION host jurisdiction. Equally, it is more difﬁcult for a The FSB (then the Financial Stability Forum) home supervisor to rely on the decisions of a host published in April Principles for Cross-border supervisor if the potential to “free ride” remains Cooperation on Crisis Management. The Principles open to the latter in a time of crisis. include joint work between home and host supervisors to consider barriers to crisis coordi- 7.2. INSTITUTIONAL CONTEXT nation and the development of common crisis A primary challenge for the FSB is to make management tools, information sharing, and signiﬁcant and rapid progress in putting in annual meetings that also include central banks place effective crisis management and resolution and ﬁnance ministries relevant to the group. arrangements for international institutions. We Authorities are to strive to ﬁnd internationally welcome that its mandate has been expanded to coordinated solutions that take account of the impact of the crisis on the ﬁnancial systems and 31Financial Reform—A Framework for Financial real economies of other countries. Stability, January 2009. Institute of International Finance • July 2009 ■ 77 However, as is clear from the high-level nature of the principles and the aspirational language of Recommendation 41: The FSB, as a priority, important parts of the document, there remains should develop a convention on cross-border a lot to be done to develop a robust and reliable crisis management. The FSB should develop a framework for cross-border crisis management. coordination and non-binding mediation role The FSB should as a matter of high priority in preparation of arrangements for cross-border enhance its principles to establish an FSB crisis management concerning individual convention on cross-border crisis management groups. to which all FSB members would adhere. This could ultimately be included in an international ﬁnancial services accord as discussed in Section 6. It should include: 7.4. SIMULATION EXERCISES Signiﬁcant enhancement of cross-border crisis A commitment to coordinated responses to simulation exercises involving participants and crises and a clear statement of the objectives authorities will be essential to building credibility of such coordination; for crisis management. The IIF noted the beneﬁts Speciﬁcation of the normal-time activities of such simulation exercises in the 2006 Proposal to be carried out by “cross-border stability for Strategic Dialogue on Effective Regulation, and groups” to be established in respect of each it is now all the more apparent that such exercises, ﬁrm and the responsibilities (and rights) based on a strong commitment of all concerned, of the home and host authorities, working would be a signiﬁcant way in which crisis closely with the colleges of supervisors for management could be improved. such groups;32 Not only can such exercises make a signiﬁcant A detailed list of data and information to be contribution to the performance of participants maintained and shared during normal times; in crisis situations and bring to light barriers Establishment of requirements for normal- to the achievement of optimal coordinated time preparations for crisis events including, outcomes, they also can foster the spirit of most importantly, regular crisis simulation cooperation and mutual understanding necessary exercises (see further below); and to achieve those outcomes. Detailed rules and guidelines for cooperative handling of a crisis situation, including Recommendation 42: Cross-border crisis early intervention and the speciﬁcation of simulation exercises should be carried out on a cooperation mechanisms. regular basis and with strong participation by relevant authorities and market participants. The Institute is encouraged that the recently established FSB Cross-Border Crisis Management Working Group will be developing a framework to implement the FSB’s principles and recommend that its work include the aspects outlined above. 32 Building on the relevant college, a cross-border stability group would also include representatives of relevant ﬁnance ministries and central banks. 78 ■ Restoring Conﬁdence, Creating Resilience 7.5. BURDEN SHARING analysis, and decision being also responsible for an appropriately larger share of the costs. A Coordination Problem It would be necessary that the commitment In the absence of a reliable mechanism for the to burden sharing in accordance with agreed allocation of the costs of ﬁnancial interventions criteria be enshrined in a high-level, binding, to support or resolve troubled cross-border international agreement. This should be agreed, banks, the decision whether or not to intervene for example, under the auspices of the G-20 and will fall on the home authorities, and they will administered by the FSB and could be developed have little incentive to take into account the costs in the context of the convention discussed in to other jurisdictions in determining their course Sub-section 7.3. of action. The agreements as to the sharing of burdens However good cooperation among super- in respect of individual ﬁrms should be reached visors is during normal times, the fact that through the FSB. It would be necessary to embed support or resolution decisions will be taken on rules of decision-making concerning whether to a home-country basis, generally by authorities intervene with ﬁnancial support. other than the supervisor, will always color the ability of supervisors to rely on each other. Constructive Ambiguity and Clarity Without a more robust international regime, the It often is said that agreements on burden sharing logical conclusions from this can lead national are not possible without undermining the supervisors to self-sufﬁciency or ring-fencing “constructive ambiguity” concerning government precautions, as is emerging today. It is essential to intervention that is necessary to avoid undue break this cycle. levels of moral hazard. This concern, although certainly a legitimate subject for debate, is not Fiscal Burden Sharing justiﬁed. As the de Larosière Group pointed out, It will be necessary to envisage the means for there is an important distinction to be made governments to intervene collectively to resolve between agreement as to how burdens will be or recapitalize ﬁrms. To do this effectively, it will shared should it prove necessary to intervene be necessary to have binding agreement on how ﬁnancially to rescue a ﬁnancial institution and a the burden of ﬁscal interventions will be allocated decision that such an intervention should actually among involved governments. It will be necessary be carried out. to develop criteria for the allocation of ﬁscal burdens of government interventions having A Common Fund regard to the extent to which each country will The resolution of crises affecting individual beneﬁt relative to others in the achievement of institutions frequently involves costs, in particular stability and consumer protection objectives. in ensuring that depositors and other protected The only way is for countries to work urgently parties do not suffer loss. In the context of the together, under the auspices of the FSB, to failure of a large and interconnected cross-border develop criteria. A good starting point for this is group, this can, depending on the manner in the criteria identiﬁed by the de Larosière Group: which the group fails, give rise to a dispropor- the deposits of the institution, its assets, its tionate burden on the ﬁscal authorities and revenue ﬂows, its share of payment system ﬂows, deposit or policyholder protection scheme of one and the division of supervisory responsibility— or other jurisdiction. the country responsible for supervisory work, Institute of International Finance • July 2009 ■ 79 Consideration could be given to the estab- 2. Transparent—Creditors and counter- lishment of a common fund which, being made parties of the institution concerned available in conjunction with the agreed burden- should be clear as to how the intervention sharing criteria, could be used to facilitate orderly affects their rights. resolution or disposition of the failing cross- 3. In line with market practices—Intervention border group and equitable depositor or policy- should not violate clearing, settlement, holder protection. However, neither the political payment ﬁnality, netting, set-off, or nor operational challenges associated with such a collateral systems and procedures. fund should be minimized. Recommendation 43: Under the auspices Overriding Public-Good Objectives of the G-20 and subject to coordination by When a government intervenes in the insolvency the FSB, criteria of burden sharing between of a ﬁnancial ﬁrm, it is by deﬁnition doing so jurisdictions in the event of the need for in order to avoid damage to society and the ﬁnancial intervention should be agreed among economy, that is, it is pursuing the public good the major countries. of systemic stability—very often protection of the payments system—or consumer protection. The effective achievement of this public good 7.6. CROSS-BORDER BANK AND should—to the extent necessary—override the FINANCIAL FIRM RESOLUTION ordinary principles of bankruptcy. Thus, all authorities involved should be empowered and REGIMES required to act so as to promote that objective. When an international bank is in danger or fails, Governments should not have to grant governments should ensure that they have the themselves ad hoc powers in such cases. The necessary legislative, administrative, and legal idea that government may act on an ad hoc basis powers in place to enable themselves to conduct depending on a particular case creates deep such interventions in a swift and effective fashion, uncertainty in the markets and damages the legal in cooperation with authorities in other jurisdic- certainty underpinning those markets. tions. They particularly should ensure that they Government intervention in a failing insti- have in place all of the relevant powers and tution should be possible at a time when the authorities identiﬁed in the IMF/World Bank institution is in difﬁculty or is in breach of its Overview of the Legal, Institutional, and Regulatory regulatory obligations. There should therefore Framework for Bank Insolvency.33 be “regulatory” as well as “solvency” grounds for government intervention in the affairs of the Special Regime for Bank Resolution relevant bank. General Principles of Intervention Obligation to Pursue the Any government intervention in a failing ﬁrm Public-Good Objective should be the following: The person or persons charged with the conduct 1. Rapid—No signiﬁcant period of of the rescue or disposition of a bank, where uncertainty should exist between the such intervention is justiﬁed by public-interest announcement of intervention and the considerations, should be placed under a positive intervention itself. obligation to pursue that objective. This should 33 IMF, April 17, 2009. 80 ■ Restoring Conﬁdence, Creating Resilience include the power to affect the rights of creditors Cross-Border Issues in Bank Failure in certain limited circumstances. Although the Multinational banks have complex corporate principle of equal treatment of creditors is a structures, and in the event of the failure of fundamental principle of insolvency law, in the such a bank, there will not be a single court or case of bank rescues it should, in appropriate ofﬁce holder charged with the liquidation of the cases, give way on a well-understood basis before group. It is in fact more than likely that an inter- the overriding objective of reducing systemic national bank will operate through more than damage. one signiﬁcant subsidiary, as well as through a Thus, for example, an administrator, receiver, number of less-signiﬁcant subsidiaries. Therefore, debtor-in-possession, or similar party appointed there are likely to be several different courts seized to control a ﬁrm in insolvency (“ofﬁce holder”) of different parts of the group restructuring. should have deﬁned powers to deliver securities and make payments to close out transactions in Facilitation of International Cooperation order to avoid systemic disruption, even before Is Key the full list of creditors and assets has been drawn up. The issue therefore is how governments should Any such powers must, to the greatest extent best manage the process of a failure of an interna- possible, be constrained within the existing law. tional bank group. The ﬁrst important step would The creation of broad discretionary powers to be to create a situation in which ofﬁce holders of vary existing contracts would make restructuring individual parts of the failed institution should existing institutions easier. However, the market be required to have regard to the situation of uncertainty that this would create would have a the group as a whole and should be permitted substantial detrimental effect on every market expressly to work with ofﬁce holders of other contract, create major blockages to innovation, parts of the group and the management of any and do signiﬁcant damage to the markets as a group entities that are not insolvent or the subject whole. of proceedings in order to maximize returns The basis of ﬁnancial markets is legal to creditors and to minimize disruption to the certainty and in particular the conﬁdence of ﬁnancial markets as a whole. counterparties that settlement ﬁnality, set-off, and In general, national legislation does not collateral rights will be respected in the insolvency mandate and may not permit cooperation among of any particular system participant. Thus, for administrators, curators, liquidators, or other example, in the recent failure of Lehman Brothers, ofﬁce holders appointed in different jurisdictions. the reason why the credit derivative markets The Institute contends that governments should remained robust was because market partici- explore establishing broad principles for cooper- pants had conﬁdence that the set-off provisions ation in the failure of international institutions, contained in open contracts would survive and be permitting ofﬁce holders to act collectively with effective in the insolvency. If there had been doubt ofﬁce holders appointed in other jurisdictions as to this point, it is likely that the impact of the over other parts of an insolvent group. failure on the system as a whole would have been substantially greater than it in fact turned out No Discrimination Based on Nationality to be. The powers of ofﬁce holders described in or Place of Residence this discussion should be designed to ensure such The aim of such cooperation should be to market-reinforcing results in future insolvencies. maximize the position of creditors of the group as a whole. Governments should consider explicitly permitting national courts to approve a scheme Institute of International Finance • July 2009 ■ 81 that could result in creditors in its own juris- establishment by treaty of an international insol- diction being potentially worse off provided that vency regime. But this is unlikely to be achieved creditors of the group as a whole are better off in in the short term. aggregate. The most important short-term practical In other words, the available assets should be steps would be for governments to engage in used to settle claimants’ rights as fairly as possible intense dialogue with each other about how to without discrimination based on jurisdiction, deal with creditors, depositors, policyholders, subject to the usual priorities and to netting and and other claimants in respect of the failure of a settlement considerations as already mentioned. cross-border institution. Such discussions might A similar principle should apply in respect of be conducted in the context of the convention depositor and policyholder protection schemes. on cross-border crisis management suggested Governments derive their tax revenue from at Sub-section 7.3. Establishment of broad their domestic taxpayers and may feel that the principles, such as the principle of non-discrim- ﬁrst call on such revenues is the compensation ination among creditors by nationality and the of domestic customers of a bank. This principle principle that ofﬁce holders should be clearly would be unobjectionable if applied consistently, empowered and encouraged to work in concert in because it would result in a position where each resolving a large group, would be highly beneﬁcial government compensated customers in its juris- in laying the groundwork for more orderly diction regardless of the place of establishment of resolutions in the future. the bank. However, in the absence of a global inter- Recommendation 44: Under the auspices of governmental agreement it is unlikely that each the G-20 and subject to coordination by the government will adopt identical policies and FSB, authorities, as a matter of priority, should that customers in different jurisdictions will all ensure that they have in place special regimes be equally protected. As a result, the resolution for bank resolution: of such crises may be slowed by (and in extreme They should have the power of early cases prevented by) a suspicion of free-riding or intervention. unequal beneﬁt, such as may arise from exclusive On determination that an institution is priorities for domestic deposit guarantee schemes systemically signiﬁcant, the winding-up of to certain assets, to the detriment of the principle such institution should have as a primary of non-discrimination across jurisdictions. objective the protection of the international It should be noted that this issue is in fact ﬁnancial system. wider than just deposit protection schemes, In order to preserve market certainty and because it also may arise in regard to guarantees conﬁdence, ﬁnancial markets law (for or other sureties that governments may offer example, concerning settlement ﬁnality, set- during crises to depositors or other creditors of off, and collateral rights) must be respected. troubled institutions. In the context of the winding-up of a cross- border ﬁnancial ﬁrm, the objective should Desirability of an International Bank be, subject to preserving the integrity of the Resolution Regime ﬁnancial system, to maximize outcomes In considering the appropriate policy response to for creditors of the group as a whole. There this range of issues, it is important to be realistic should be no discrimination between about what can be achieved. It may well be true creditors on grounds of nationality or that the optimal way of dealing with the failure geographical location. of an international banking group would be the 82 ■ Restoring Conﬁdence, Creating Resilience Commitments and Recommendations Importance of Coordination in an Recommendation 3: A global framework for the International Market supervision and regulation of internationally active insurance ﬁrms on a group-wide basis Commitment I: The IIF membership will should be developed under the leadership of the dedicate the necessary resources and engage IAIS. with their colleges of supervisors on a high- priority, fully committed basis. Recommendation 4: Clear strategies should be developed for the withdrawal of governments Recommendation 1: The FSB should from ownership positions in ﬁnancial proceed quickly and with continued institutions and for ending extraordinary determination in taking the steps necessary liquidity and market support measures. Such for the establishment and operation of strategies should be carefully coordinated well-functioning colleges of supervisors internationally to be fully effective and minimize for internationally active banks. Ensuring the risk of unanticipated consequences. effectiveness, high-quality cooperation, and appropriate consistency in the operation of these colleges should be a high-priority task A Shared Responsibility to for the FSB and supervisory authorities. Achieve Resilience Recommendation 2: National authorities Commitment II: The IIF membership will as a should coordinate closely in respect of the matter of ﬁrst-order priority continue the good wide array of regulatory proposals that are progress to bring their risk management and currently under consideration, working other business practices into alignment with the through the relevant international standard- recommendations of the Market Best Practices setting bodies. Such coordination should go Report. beyond the level of principle or direction and ensure consistency of speciﬁc regulation. Commitment III: The standards set out in the There should be timely and consistent global Market Best Practices Report have become implementation of Basel II, appropriately a benchmark for large, internationally active modiﬁed. Coordination becomes increasingly ﬁrms. The industry welcomes the use of this and important given emerging fragmentation. other reports, such as the Senior Supervisors Group Report of March 6, 2008, in the supervisory assessment of the quality of risk management of such ﬁrms. Institute of International Finance • July 2009 ■ 83 Commitment IV: The industry is committed Recommendation 7: It is essential that to continue to implement reforms in regulation be effective while ensuring that compensation practices so as to align markets remain as efﬁcient as possible. The these practices with the IIF Principles and principles of effective regulation should be recommended leading practices, as well as followed, including: with the FSB Principles. In this regard, the IIF intends to monitor developments in Clearly identiﬁed objectives; industry practices and to provide an informal Clear understanding of impacts, both assessment in the forthcoming report of the positive and negative (but avoiding IIF Steering Committee on Implementation mechanistic or purely quantitative in November 2009 and to conduct a survey of methods); industry practices in 2010. An incentives-focused methodology; and Recommendation 5: Regulatory authorities Incorporation of consultation and should develop appropriate supervisory dialogue. guidelines on compensation, in line with FSB Principles, in a timely manner so as to Recommendation 8: There should be a reduce market uncertainty. The FSB should structured, ongoing dialogue between the ensure that these guidelines are consistent, FSB, the standard-setters, and the industry in all important respects, across jurisdictions to support high-quality, effective, and well- and that a reformed regulatory environment coordinated international regulatory reform. also provides for a level playing ﬁeld on This should cover all ﬁnancial sectors and all compensation between the regulated and non- types of regulation (prudential and conduct of regulated segments of the ﬁnancial market. business). Commitment V: The IIF membership will Recommendation 9: Resilience depends in undertake the efforts and investment necessary large part on the risk management of ﬁrms to promote the success of more outcomes- and the functioning of markets. Regulation focused, judgment-based supervision. This cannot do the job on its own. It is essential will include developing standards and norms to restore and enhance market discipline, of behavior to underpin a better quality of in particular by ensuring that creditors of relationship with supervisors. ﬁnancial institutions (other than depositors and insurance policyholders, and subject to Recommendation 6: Authorities should the rules of priority in insolvency) are at risk continue to develop a more consistently of appropriate loss in the event of failure. outcomes-focused, judgment-based approach Reform should lever and seek to enhance the to regulation. The IIF recommends increasing positive dynamic between markets operating the resources, expertise, and skills of under effective discipline and more effective supervisors to implement macroprudential regulation. oversight. 84 ■ Restoring Conﬁdence, Creating Resilience Achieving Resilience Through Recommendation 13: There should be dialogue the Cycle With Prudential and between the ofﬁcial sector and the industry to Accounting Standards develop effective approaches to the very difﬁcult task of evaluating the cycle and deciding when Capital to apply buffer mechanisms, on the upside or the downside. Commitment VI: Levels of capital in many parts of the system were insufﬁcient. The IIF Commitment VIII: The IIF agrees that the agrees that overall levels need to be increased, quality of capital required needs to be reviewed. within the framework of the Basel II risk-based The IIF membership is ready to work closely approach, as compared to pre-crisis levels. The with the ofﬁcial sector to achieve an outcome IIF membership stands ready to work with the that reﬂects the lessons learned from the recent regulatory community on objective analysis period. of the cumulative net impact of proposed regulatory changes. Recommendation 14: Consistent international requirements for the deﬁnition and quality of Recommendation 10: The cumulative capital, in particular Tier 1 capital, should be impact of proposed enhancements of capital developed. They should be applied consistently requirements and other regulatory and on a global basis. The beneﬁts of Tier 2 capital, accounting changes should be fully assessed including convertible Tier 2, should not be prior to ﬁnal decisions being made. underestimated. Recommendation 11: The timing of Controlling Leverage introduction of new requirements should be carefully considered to ensure that they do not Commitment IX: The IIF agrees leverage was hinder recovery. too high and needs to be appropriately controlled in the future. Commitment VII: The IIF supports measures to counter cyclicality by building resources in Recommendation 15: A simple leverage ratio good times that can be drawn down in bad runs the risk of undermining its own objectives. times. Any measure to contain leverage should take account of differences in business models Recommendation 12: Buffers, whether and funding structures, major differences in created by capital or reserves, should be able risk proﬁles, distinct market practices and to be drawn on when needed without adverse characteristics, and differences in accounting consequence. standards. Leverage should be addressed as a supervisory tool for use as part of the Pillar 2 dialogue between a ﬁrm and its supervisor. Institute of International Finance • July 2009 ■ 85 Accounting ﬂows due to a reporting entity. Work currently in progress to review fair-value and accrual Recommendation 16: There should be a accounting for ﬁnancial institutions should comprehensive, high-level dialogue on current continue with urgency. It should also address, accounting standards in light of the crisis as part of the comprehensive simpliﬁcation of and the changing regulatory environment. ﬁnancial instrument reporting, existing rigidities This should involve all relevant parties while in hedge accounting. respecting the independence of the standard- setting process. Recommendation 21: Reporting changes in an entity’s own credit in earnings is a source of Recommendation 17: Achieving overall controversy. The debate should consider whether convergence in international accounting elimination of recognition of changes in the standards requires active support from reporting entity’s own credit quality in reported all concerned, including the industry and earnings would provide simpler, more direct, and securities and prudential regulators. There more decision-useful information to the market. should be a renewed commitment by all stakeholders to a clear plan for timely Recommendation 22: Consistent guidance adoption of a single, high-quality set of should be issued by the major standard-setters accounting standards. to allow the use of reasonable interpretation in assessing loan losses under the incurred- Recommendation 18: Exceptional processes loss model. Such guidance should be given should be in place to provide guidance on as the unambiguous backing of securities expedited a basis as possible while allowing regulators in order to help avoid the overly for rapid consultation with stakeholders in the narrow applications that have contributed to event of extraordinary occurrences. procyclicality. The current review to consider the reﬂection of a wider range of credit information Recommendation 19: While progress has in standards for loan loss provisioning must be been made to date on valuation in less-active given priority. markets, more needs to be done. Standard- setters should develop a common framework that reduces the complexity and multiplicity Liquidity of existing impairment models on the basis of all available relevant information. This should Commitment X: IIF members have already be done on a fully convergent basis, taking into enhanced their liquidity risk management and, account the lessons learned from the crisis. subject to difﬁcult market conditions, have been building liquidity buffers and working toward compliance with the IIF and Basel liquidity Recommendation 20: Fair-value accounting principles. In addition, they continue to manage has clear beneﬁts in appropriate contexts. their liquidity to ensure that local liquidity However, questions have been raised needs can be met. IIF Members will continue concerning its effects on cyclicality, and it may the ongoing enhancement of their approach to not always provide the best reﬂection of cash liquidity management. 86 ■ Restoring Conﬁdence, Creating Resilience Commitment XI: Good liquidity risk Recommendation 24: In determining a ﬁrm’s management should take into account liquidity buffer, mechanistic approaches that do local market needs. In addition, the IIF not take into account the overall business model, is committed to exploring ways in which funding proﬁle, and market context of the ﬁrm ﬁrms could organize their cross-border are likely to be counterproductive and should not business to reduce the concerns of authorities be adopted. that individual jurisdictions would suffer disproportionate loss in the event of an Recommendation 25: Overly narrow deﬁnitions insolvency. This should take place in the of eligible liquid assets for liquidity buffers context of the ongoing dialogue between large should be avoided as a matter of proportionality ﬁrms and the authorities concerning the and to avoid unintended consequences. The information necessary to plan for the orderly deﬁnition of eligible assets should be both exit of the ﬁrm should that prove necessary coordinated internationally and developed in as discussed in Section 4. Such an approach tandem with revised (and coordinated) central would take into account the legal structure of bank lists of eligible collateral for ongoing the group and differences in insolvency laws monetary operations and (non-emergency) across jurisdictions. The IIF stands ready to liquidity purposes. work with the ofﬁcial sector to reduce the real dilemmas that the tensions between global Recommendation 26: There should be and local goals for good liquidity management comprehensive international coordination. present. This includes liquidity reporting requirements, as proliferation of detailed but inconsistent Recommendation 23: Although the serious requirements across jurisdictions will impose issues raised by failures of major market undue burdens and costs, contribute to systemic participants need to be addressed, the vulnerability, raise compliance risk, and signiﬁcant drag on system efﬁciency created by distract from the clarity of internal reporting to “trapped pools of liquidity” also is important management. and needs to be taken into account. Self- sufﬁciency or stand-alone approaches to Commitment XIII: The IIF agrees that a liquidity regulation should be resisted by signiﬁcant component of funding should be regulators. comprised of stable elements, as part of well- understood overall funding plans. Commitment XII: It is necessary to hold liquidity buffers against liquidity risk. This is Recommendation 27: A strict, mandatory core- an important part of a robust overall approach funding ratio should not be adopted. Such an to liquidity risk management. approach is unlikely to reﬂect different degrees of stability and would be prone to material unintended consequences (such as an increased volatility that would result from enhanced competition for deposits). Institute of International Finance • July 2009 ■ 87 Financial Stability Through Commitment XVII: The IIF agrees that Macroprudential Oversight the supervisory review process applied to ﬁrms should be founded on a risk-based Commitment XIV: The IIF’s recently- approach. Accordingly in determining what established Market Monitoring Group is if any supervisory measures should be taken, committed to identifying and assessing supervisors should incorporate analysis of the systemic vulnerabilities and issues emerging nature and degree of a ﬁrm’s impact on the in the markets. It stands ready to discuss such system should that ﬁrm fail. Members are developments with the ofﬁcial sector. committed to working with supervisors to make such an approach effective. Recommendation 28: Macroprudential analysis at the international level will need Recommendation 30: Artiﬁcial restrictions on to be translated into actionable measures for size or diversiﬁcation should be avoided. Large, implementation. Given the G-20’s mandate complex institutions play an important role in to the FSB, the FSB’s resources should be supporting the global economy. Restrictions on augmented for this purpose. size or diversiﬁcation could produce materially distorting effects and unmanageable risk Commitment XV: The IIF agrees that patterns within the system. The industry agrees, authorities will require access to all relevant however, that in addition to ensuring that such and material information to carry out effective institutions meet the highest standards of risk ﬁnancial stability oversight. The industry will management, it is essential that they be subject work with regulators to identify and provide to effective market discipline. To this end, there such information. should be developed the infrastructural, legal, and process reforms necessary to ensure that all ﬁrms can exit the market in an orderly fashion Recommendation 29: It would be without causing undue trauma to the system. counterproductive to create a formal or published category of highly systemically relevant ﬁrms. Systemic risk does not reside Recommendation 31: Restrictions on the in single entities but in the interconnectedness business models or range of activities of ﬁrms of ﬁrms, markets, and players. It is a rapidly should be avoided. While it may be appropriate evolving and multifaceted concept that should to require additional capital in respect of be addressed using appropriately sophisticated higher risk activities, there is no good case to and adaptive techniques, which avoid prevent ﬁrms from engaging in a full range of distortions and moral hazard. ﬁnancial activities in accordance with sound and well-managed business models. Far from being a source of vulnerability, diversiﬁed, well- Commitment XVI: The IIF agrees that the managed, and proﬁtable ﬁrms provide a source degree of systemic relevance of a ﬁrm may of real resilience for the overall system. require more intensive supervision. Members are committed to working with supervisors to make such an approach effective. 88 ■ Restoring Conﬁdence, Creating Resilience Commitment XVIII: Consistent with the Improving Market Infrastructure principle that no ﬁrm should be designated and Mitigating Risks of too big to fail, large or highly interconnected Interconnectedness ﬁrms should examine with the authorities the risks that their role in markets and products Commitment XX: In line with the commitments create, to help the authorities assess what already made by industry participants, and would happen in event of their failure. The reiterated in the industry letter of June 2, 2009, ongoing dialogue between such ﬁrms and to the President of the Federal Reserve Bank of their authorities should include consideration New York, and building on ongoing progress, of all the information necessary to plan for industry is committed to CCP clearing of the orderly exit of the ﬁrm should that prove eligible standardized CDS contracts and OTC necessary. transactions. Commitment XIX: Riskier activities should be Commitment XXI: In line with the continuing subject to appropriately risk-weighted capital work of the International Swaps and Derivatives requirements. Such capital requirements Association (ISDA), standardization of CDS and should be calibrated so as to reﬂect the risk of other OTC contracts should be pursued to an those activities and consideration should also appropriate degree. be given to relevant cost of funding issues. Recommendation 34: It is important, however, Recommendation 32: The FSB should that end-users of CDS and other OTC contracts coordinate the engagement of supervisory remain able to effectively hedge against speciﬁc colleges in the implementation of the policy situations. Accordingly, standardization should conclusions arising from macroprudential not be pursued to the extent that it eliminates oversight and analysis, as well as in the the ﬂexibility achievable by the continuing assessment of emerging ﬁnancial stability risks. availability of bespoke transactions. Recommendation 33: To achieve Recommendation 35: Authorities’ intervention macroprudential aims effectively and in the CDS and OTC markets should be strongly efﬁciently, a structured international dialogue coordinated internationally. The market is should be put in place between authorities international, and the establishment of artiﬁcial and ﬁrms. This should involve an industry boundaries should be avoided. platform, representing ﬁrms subject to FSB colleges and the supervisors involved in those Recommendation 36: Systemically relevant colleges. infrastructure providers should have access to central banks’ emergency liquidity provision. Institute of International Finance • July 2009 ■ 89 Commitment XXII: In line with the industry Recommendation 40: The point has been letter of June 2, 2009, to the President of the reached where international cooperation Federal Reserve Bank of New York, to the and coordination should be put on a ﬁrmer extent that CDS contracts, OTC interest rate footing. We recommend the development of a derivative trades, and OTC equity derivative non-binding inter-governmental accord on trades are not subject to CCP clearing, they ﬁnancial markets and ﬁnancial services. will be recorded in a trade repository to ensure appropriate transparency of the market. Cross-Border Crisis Management Recommendation 37: The Basel Committee and Financial Firm Resolution should develop further standards for Regimes model validation and monitoring in rating agencies, especially for structured products. Recommendation 41: The FSB, as a priority, There should be independent veriﬁcation of should develop a convention on cross-border rating agency processes of model validation, crisis management. The FSB should develop governance, and monitoring by means of a coordination and non-binding mediation a self-regulatory organization or a new role in preparation of arrangements for independent international review body. cross-border crisis management concerning individual groups. Recommendation 38: The industry and the ofﬁcial sector should continue to work together Recommendation 42: Cross-border crisis to build on the new foundations already simulation exercises should be carried out on a developed to ensure high levels of transparency regular basis and with strong participation by for securitization products and markets so relevant authorities and market participants. that securitization can continue to play its important role in providing ﬁnance for key Recommendation 43: Under the auspices asset classes. of the G-20 and subject to coordination by the FSB, criteria of burden sharing between jurisdictions in the event of the need for Resisting Fragmentation of ﬁnancial intervention should be agreed among International Markets the major countries. Recommendation 39: The FSB should, Recommendation 44: Under the auspices of together with the IMF, make addressing the G-20 and subject to coordination by the fragmentation of the international ﬁnancial FSB, authorities, as a matter of priority, should market a permanent objective. This should ensure that they have in place special regimes complement the FSB’s important task for bank resolution: of ensuring enhanced cooperation and coordination among authorities. 90 ■ Restoring Conﬁdence, Creating Resilience They should have the power of early In the context of the winding-up intervention. of a cross-border ﬁnancial ﬁrm, On determination that an institution the objective should be, subject to is systemically signiﬁcant, the winding- preserving the integrity of the ﬁnancial up of such institution should have as a system, to maximize outcomes for primary objective the protection of the creditors of the group as a whole. There international ﬁnancial system. should be no discrimination between In order to preserve market certainty creditors on grounds of nationality or and conﬁdence, ﬁnancial markets law geographical location. (for example, concerning settlement ﬁnality, set-off, and collateral rights) must be respected. Institute of International Finance • July 2009 ■ 91
"RESTORING CONFIDENCE CREATING RESILIENCE"